Introductory Economics Course Companion 9781350363274, 9780333579138

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A CKNO WL EDG EM EN TS

The author and publishers are grateful to the following for permission to reproduce copyright material: Barclays Bank plc for material on page 191. Daily Mirror for extract on page 71. &onomica for Figure 28.5 form A. W. Phillips, 'The

relationship between unemployment and the rate of change of money wages in the UK, 1861-1957',

1958. Financial Times for extracts on pages 63, 198-9, 230-1. The Guardian for extracts on pages 88 and 190.

The Controller of Her Majesty's Stationery Office for Tables 2.1, 17.1, 21.2, 27.2, 28.1 and 32.1 and Figures 2.1 and 2.2. lEA for Table 2.3. Longman Publishers plc for material on pages 13--15. The Times Newspapers plc for material on page 187. UNIDO for Table 30.7. Western Mail for material on page 77.

They would also like to thank the following examination boards for permissions to reproduce examination questions, though the boards do not take any responsibility for the answers provided by the author: Associated Examining Board Joint Matriculation Board Northern Ireland Schools Examination and Assessment Council University of Cambridge Local School Examining Syndicate University of London School Examining Board Every effort has been made to contact all the copyright-holders, but if any have been inadvertently overlooked the publishers will be pleased to make the necessary arrangement at the first opportunity.

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PREFACE

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This book is designed as a course companion for those studying 'A' -level Economics and equivalent courses. The aim is not to provide a substitute for a main course text. Rather the aim is to provide an introduction to the different topics in the syllabus, to identify the most common errors and to provide practice at answering questions so that understanding of the subject will be improved. It is hoped that by supplementing the information given in conventional textbooks economic awareness will be increased, and that this will be reflected in higher assignment marks throughout the course and in an improved examination performance. Each chapter follows the same pattern. A topic summary provides the essential outline of the most important concepts, ideas and relationships associated with each topic on the syllabus. This will introduce readers to the subject-matter of the topic. The concise nature of the topic summaries will appeal to students who require more information on topics they have read about elsewhere, or who require a brief, but thorough, grounding in the topic before moving on to a more advanced treatment. The topic summaries are written so as to be accessible to students of all abilities. Each chapter also contains detailed information on mistakes most commonly made, particularly by students new to the subject. Often basic concepts are mistaken for one another and the section 'Common Mistakes to Avoid' in each chapter identifies those concepts which are commonly confused and explains the differences between them. In the section 'Questions and Answers' we give answers to typical examination questions. All types of examination question, multiple-choice, data response and essay, are included throughout the book and most of the questions are taken from past examination papers. Full and complete answers are given to each question and in total there are over 75 examination-type questions and answers. While I am grateful to the examination boards for permission to reproduce their questions, they are not necessarily in

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agreement with the answers given here and they accept no responsibility for them. Nevertheless, it is hoped that students will find the questions and answers helpful, but, remember, all examiners know that any particular question can often be answered in a variety of ways and no claim is made here that the answers given in this book are definitive. It is certainly not recommended that they be learned by rote in the hope that they reappear on an examination paper. The aim of including answers in this book is to show one way in which each of the questions can be answered and to give an indication of the standard required to achieve success in the examination. It is hoped that having seen examples of good work students will aim to achieve and better the standard set here. In addition to examination-type questions and answers, this book contains over 220 'Review Questions and Answers' designed to probe and test understanding of each topic on the syllabus. The review questions are reproduced from the core textbook Introductory Economics (Barry Harrison, Charles Smith and Brinley Davies, Macmillan, 1992), and, while some of these questions were constructed by my co-authors of that book, the answers given here are my own work. Many people have worked long and hard in the production of this book, and if I do not mention them all by name I am nevertheless grateful to them. As always, my wife Lea, and sons, Paul, Matthew and Simon, have provided a great deal of help, advice and support which all authors need. When I wrote my first book my eldest son had not started school and my youngest son was not even born. They are all now old enough to help with the humdrum chores around the house and while they might not always like sharing them, they are at least cheerful about doing them. Again I am grateful to the entire team at Macmillan but must make special mention of my publisher, Stephen Rutt, who has been a constant source of guidance and encouragement. I must also thank Keith Povey and his editorial team for remov-

viii

PREFACE

ing many errors from my typescript and for transforming it into a version fit for the printer. Finally I have received helpful advice and comments on each chapter from Stan Goodman of Rickmansworth School, Hertfordshire, Phyllis Palmer of Dinnington Comprehensive School, Sheffield, and John Wigley of

Haberdashers' Aske's School, Elstree. All of those mentioned above have suggested many improvements to the text, but as I have not always accepted their advice I am unable to implicate them in any errors or omissions that remain.

Nottingham

BARRY HARRISON

ix

AN INTRODUCTION TO STUDY SKILLS

Learning how to study effectively is an important skill to develop if knowledge and understanding of a subject are to grow. This introductory section sets out some general points of good practice.

Reading and Note-taking There are different reading techniques and which is most suitable depends on the nature of what you are reading and why you are reading it. The main techniques are easily summarised.

This is a technique where we simply focus on the main headings and sub-headings which are listed as an initial guide to the relevance of the material covered. In other words scanning is used to identify those sections which require more careful attention.

detail to adopt an analytical approach. You will derive greatest benefit from detailed reading when you question what you read. For example, when you read a particular argument try and identify the circumstances necessary for the argument to hold, try and think up examples to illustrate points you read about and so on.

Note-taking Compiling a set of notes is essential if you are to derive full benefit from the material you read. However notes should be just that, a summary of what you have read. There is sometimes a great temptation simply to rewrite what has been read. In fact this takes considerable time, leads to a copious set of notes that are less useful than the book from which they were taken and in no way improves understanding of the subject. Try to compile a set of notes which summarise in your own words what you have read.

Skimming This technique involves reading material quickly and is useful when we are already familiar with a topic and simply require a different approach to a topic or a different set of examples. Using this technique it is often possible to skim two or three pages a minute.

Detailed Reading This is reading undertaken to build up knowledge and understanding of the subject. By comparison with the other techniques of reading described above, detailed reading is a slow process and requires far more concentration. It is important when reading in

During your course you will almost certainly be required to produce several assignments. In general it is important to complete work in good time. Rushed work seldom reflects an individual's ability. Before writing an assignment it is usually best to plan what you intend to do in the assignment and how it will be organised. Ideally the plan should cover the whole assignment. A plan should include only the amount of detail necessary for you to remember all of the points you intend to include in your assignment. Having completed your plan it is a good idea to refer to the title of your assignment and check that your plan actually covers all of the relevant material and provides a suitable answer to any questions posed.

AN INTRODUCTION TO STUDY SKILLS

X

Preparing for the Examination Revision How and when to revise are matters of individual judgement. However, for most people it is better to regard revision as an on-going process: something that begins when the course starts! Revision in this sense implies paying particular attention to those parts of the course you have difficulty with or which you do not fully understand. This is particularly important in a subject like economics where topics interrelate so that an understanding of one topic is necessary for an understanding of others. For example, economists use supply and demand techniques to explain the behaviour of markets. If these concepts are imperfectly understood it will be difficult to understand the behaviour of the different markets covered by the syllabus you are following. A solid body of knowledge and understanding takes a considerable time to build up. It is not something that can be achieved in the few weeks before an examination. Final revision should be seen more as a consolidation phase when knowledge and understanding are strengthened. A useful idea before final revision begins is to draw up a revision plan. This should identify the specific times in the run up to the examination when different topics will be covered and understanding checked. One important point to remember is that revision will almost certainly take longer to complete than you anticipate. The further into your revision you go, the more difficult it will be to make progress. In other words be sure you begin revision early enough, so that you have sufficient time to cover the whole syllabus. As part of your revision programme it is important to practise answering questions from past examination papers. Make sure you have plenty of practice at answering all of the different types of questions (multiple choice, data response, essay and short answer questions). If possible it is a good idea to have these marked by your teacher but this may not always be easy, especially if you are part of a large group. If it is not possible, ask your teacher for a few hints about the way different questions might be tackled and reassure yourself that you are thinking along the correct lines. It is also useful to obtain the chief examiner's reports on past question papers. These give a good indication of what the chief examiner was looking for in the responses to the different questions, but also gives a guide to the standard required for success in

the examination. Possibly of even more importance is that the reports provide information on the most common errors made by candidates in the examination. Few of us are immune from such errors. The more information you have on the mistakes most commonly made, the better your chances of success.

In the Examination When . you are told to begin the examination it is important to read the question paper fully before you respond to any questions. Indeed it is a good idea to read the question paper more than once and think about what each question is asking you to do. Experience confirms that on a second reading, questions which seemed difficult are often easier than they appeared. Before you begin your response to any question make a brief plan of what you will include in your answer. Pay particular attention to key words that indicate the type of approach required. Some of the more common key words are explained below. Briefly or Outline These words tell you that a sentence or a few sentences are all that is required for this part of the question. As your guide, look at the number of marks that are available for an answer to questions that begin with these words. Sometimes all that is required is a straightforward definition of a particular term or concept. At other times a little more explanation is required. Explain or Analyse These words ask you to demonstrate that you understand how concepts relate to one another and the assumptions that underpin a particular argument. For example, a phrase economists often use is 'other things equaf. Being able to identify these other things and understanding what might happen if they do not remain equal is an analytical skill. Assess, Evaluate, Discuss or Examine Questions which include these words require a balanced approach. Reasoned judgements must be made about different arguments and their possible validity assessed. Where appropriate it is important to consider advantages and disadvantages and your points must be supported by argument. Illustrate This simply means 'explain with examples'. Since you are asked to include examples in your explanation it is important that you do so. Failure to include examples will no doubt result in lost marks.

CHAPTER 1

WHAT IS ECONOMICS?

Topic Summary When you begin your course in economics, as well as your hopes for examination success you probably have hopes about what you will have learned by the end of the course. In one way or another the economy receives a great deal of coverage in the media and you will no doubt wish to understand such coverage. Typical headlines might read:

'Sterling was weak against the dollar but gained ground against the Deutschmark' 'Unemployment rose again last month though the underlying trend is downwards' 'Britain's trade was in the red again with the biggest gap ever recorded between manufacturing exports and manufacturing imports' By the end of your course you will no doubt understand fully what each of these statements implies. But, much more important than this, you will have some idea of what causes these problems and your own opinions on how to deal with them. However to achieve this you must begin at the beginning, and in this chapter we aim to answer the question 'What is economics?' In a nutshell, economics is about the economic problem. But what is 'the economic problem' and how can we suggest that there is only one economic problem? After all, we have mentioned several economic problems above: the exchange rate, the balance of payments, unemployment and inflation. We could add many more problems to this list without any difficulty at all if we wanted to, but the important point to stress is that all of these problems are in fact part of a much greater problem. It is this greater problem which economists refer to as 'the economic problem' and the entire study of economics stems from this central economic problem. It is therefore extremely important to understand exactly what is meant by 'the economic problem'.

Scarcity Scarcity is at the heart of the economic problem. However, by scarcity economists do not necessarily mean that something is rare or that there is not much of it. Instead, scarcity is defined as a situation that exists when more of something is desired than is currently available. In this sense most of the goods and services we can think of are scarce. There is no doubt that for society as a whole there are many unsatisfied desires. Most people can think of material things they would like but cannot at present afford. A new car, a caravan, a second home, additional holidays, and so on, are examples that spring to mind. No matter how prosperous a country becomes the desires of society go on growing. In the UK there are now four times more cars on the roads than there were twenty years ago, but still the desire to possess even more cars is no closer to being satisfied! The existence of these unsatisfied desires, whatever form they take, is what economists mean by scarcity. The question to ask is why countries are unable to satisfy all of their material desires. In fact goods and services are scarce because they are made from resources such as land, labour and capital. At any moment in time there is a limited supply of these resources, but there is no such limit on the desires of society for the output that these resources can produce. This means that some of society's desires will always be unsatisfied. This is one part of the economic problem.

Choice Because society cannot have all the goods and services it desires at any one time, it is forced to make choices. In other words, because of scarcity, society is forced to choose. In fact there are three fundamental choices which all societies must make. In summary these are:

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INTRODUCTORY ECONOMICS COURSE COMPANION

What output to produce. Because resources are scarce, society cannot have all the goods and services it desires; it must therefore choose which goods and services will be produced. How to produce. There are various ways of producing any given output. For example, it is often possible to substitute machinery for labour and society must therefore choose the way in which its factors are to be combined. For whom to produce. Society must decide how its output is to be distributed among consumers. Will there be equal shares for all, or will some people have more output than others and, if so, how much more? Choice is the second part of the economic problem, which can therefore be summed up as scarcity and choice.

Cost Throughout your course you will find many references to the term opportunity cost. You will quickly realise that this is one of the most fundamental concepts in any study of economics. It is particularly relevant to decisions about production or consumption because there are alternatives to consider. How many alternative uses can you think of for timber and steel, for example? Or what about your weekly pocket money? How many alternative uses can you think of for that? The point to grasp is that, if resources are used to produce or consume one thing, we must do without the alternative good or service that could have been produced with the same resources or purchased with the same money. The alternative which is forgone is the opportunity cost of what is produced or consumed. For example, if the government, on behalf of society, chooses to build a new university, the opportunity cost of this might be a new hospital or a new housing estate. Great care must be taken here. In this case the opportunity cost of the university is not the hospital and the housing estate. Society does not do without both of these. If, in order of preference, society would choose a university first, a hospital next and a housing estate last, then the opportunity cost of the university is the hospital, because this is what society will do without if it uses its resources to build a university. In practice, most of society's choices about the use of its resources do not mean choosing one thing in preference to another. They involve choosing more of one thing and having less of something else. One point to note in passing is

that economists often refer to opportunity cost as

real cost to indicate the real sacrifices involved in

making decisions about how resources are to be used. Simply remember that opportunity cost and real cost are different ways of saying the same thing.

Production Possibility Curves Sometimes opportunity cost is illustrated by means of a production possibility curve. A production possibility curve simply shows the different combinations of output that society can produce at any one time when all of its available resources are used or employed. For example, if we assume that society only produces two goods, good X and good Y, we can illustrate a typical production possibility curve as in Figure 1.1. Since a production possibility curve shows the maximum amount that can be produced from society's scarce resources, it follows that any point on the curve, such as A or B, are points of full employment. Any point, inside the curve, such as point C, represent points at which not all of society's resources are fully employed. In other words there are unemployed resources in the economy. It is clear from Figure 1.1 that, when the economy is at point A, it is producing 200 units of good X and 615 units of good Y; whereas when the economy is at point B, it is producing 450 units of good X and 340

Figure 1.1 A typical production possibility curve 700 600 500 ::...400

~

300

.c

200 100

100 200 300

400 500

600

Good

X

Note Points A and B are points of full employment. At point C there are unemployment resources.

WHAT IS ECONOMICS?

units of good Y. We can see from this that if the economy is at point A, the opportunity cost of increasing the production of X from 200 units to 450 units is 275 units of good Y. This is because the increased production of X is only possible if the production of Y is reduced by 275 units. On the other hand if the economy is at point C, that is, currently producing 200 units of good X and 250 units of good Y, it is possible to increase the production of both goods simultaneously. It is also possible to increase the production of one good without reducing production of the other. In other words when the economy is at point C, increased output has no opportunity cost. The reason is that at point C there are unemployed resources which can be drawn into production.

Questions and Answers Questions 1 (a) What problems have prompted several countries in Eastern Europe with centrally planned economies to make greater use of the price mechanism in directing economic activity? (b) Do these changes in Eastern Europe imply that a wholly free enterprise economy faces no problems in the task of resource allocation? ULEAC, June 1991

2 Opportunity cost arises because: (1) society's wants exceed its ability to satisfy them, (2) resources are scarce and have alternative uses, (3) all goods consumed by society require scarce resources.

Economic Systems Conventionally the discussion of economic systems focuses chiefly on market economies and centrally planned economies, though in its extreme form neither system exists anywhere in the world. Despite this the distinction is important because real world economies can be thought of as being more like one type of economic system and less like the other. In fact all economies are more properly termed mixed economies because they contain a mixture of both types of system. However, in recent years economies such as the Russian economy, which were regarded as largely centrally planned, have shifted dramatically towards market economies and away from central planning. The reasons for this are examined in the answer to Question I on pp. 3--5.

Common Mistakes to Avoid Scarcity and Rarity Take care to avoid confusing scarcity and rarity. Scarcity is measured relative to the amount of something which is desired. Rarity is measured relative to the amount of something which is available. Thus motor cars are scarce because society as a whole desires more of them than is currently available. However they are certainly not rare! On the other hand we might agree that an original Van Gogh painting is rare because there is only one original in existence.

3

(A) (B) (C) (D) (E)

I, 2 and 3 are correct. I and 2 only are correct. 2 and 3 only are correct. I only is correct. 3 only is correct.

Answers 1 (a) In the centrally planned economies of Eastem Europe there was a high degree of state ownership of the means of production which meant that the government, through its planning agency, had to plan the output of the different sectors of the economy. The collapse of these economies indicates that central planning operated inefficiently. In the recent past we have learned a considerable amount about the planned economies of Eastern Europe and they are clearly struggling to overcome problems of inefficiency, poverty and pollution. A major case of these problems was that most resources were state owned and there was little in the way of private ownership. Most production was not therefore undertaken for profit and producers had little incentive to improve their product or the way it was produced. Another source of inefficiency was that, once established, plans were difficult to alter. In these circumstances, if consumers demanded more of certain products and less of others, it was impossible to adjust production quickly and there were

4

INTRODUCTORY ECONOMICS COURSE COMPANION

surpluses of some goods, shortages of others, and little prospect that the situation would improve. It is hard to imagine a more graphic example of ineffi· ciency than this: an economy producing goods which people do not want, and simultaneously failing to produce enough of those goods which people do want, with no prospect of change! Industry in the centrally planned economies of Eastern Europe also operated inefficiently for another reason. As part of the planning process, each production unit in the economy was assigned a target level of output. However, assigning target levels of output to individual factories and farms provided an incentive to underproduce. After all, any target that was met would most likely be increased when the plan was redrawn. This has been a major cause of poverty in the economies of Eastern Europe since the amount a country can consume is largely determined by the amount it produces. In addition the economies of Eastern Europe directed vast amounts of resources towards military activities such as the production and development of armaments. If resources are devoted to military purposes, they are not available to produce goods and services the population might otherwise desire. Similarly drawing up the plan involved a considerable opportunity cost. Tens of thousands of officials were employed simply to gather data on resource availability, estimate the productive potential of factories and farms and decide the level of output each unit was to produce and, to a large extent, the way it was to be produced. The plan itself was so complex it required the aid of the most powerful computers. These resources could have been used to produce other goods and services, had they not been used for planning purposes. However, it was not just in production that inefficiency was evident. The centrally planned economies also performed inefficiently in the distribution of output. Long food queues were a daily occurrence in many places and this represents a considerable waste of that most valuable resource, time. Moreover food queues are an indication that there is a shortage in the shops. However, in the planned economies of Eastern Europe this occurred when food was· rotting in storage depots or in the fields because it was unharvested. Centrally planned economies have also been criticised because of the degradation of the environment they allowed. Here again inefficiency in production has been a major cause of such environmental degradation. If waste materials, including toxic waste, are simply dumped into a river or lake, the disposal cost to the producer is zero since the waste

is not treated. However the creation of treatment plants requires resources which, because industry operated so inefficiently, the planners deemed could not be spared from other uses. The environment was therefore used as a resource which had no opportunity cost. In other words it was used as a free resource. These are the major problems that have prompted the East European countries to move away from central planning and make greater use of the price mechanism in directing economic activity. (b) There are clearly problems with central planning and these problems have led to the introduction of wide-ranging reforms aimed at creating a more decentralised economy with greater reliance on the market as a means of allocating resources. Market economies have certain basic characteristics and in particular the government plays little part in the allocation of resources. Instead what is produced is decided by consumers and producers, with the latter being guided in their decisions by the profit motive. In other words, producers will supply those goods and services which offer the highest profit. This is only possible if individuals are permitted to own the means of production such as land and machinery. Therefore an important part of the reforms in the East European economies has been the return of certain assets to private ownership. In free market economies resources are allocated through the price mechanism. Thus, when consumers buy a good or service, they are in effect casting a vote for the continued production of those goods and services. When particular goods or services become more popular, then more votes are cast for these than was previously the case and, as a result, their price rises. The higher price encourages producers to increase their output because by doing so they will earn higher profits. As a result, resources are diverted to the production of those goods and services which have become more popular with consumers. The mechanism also works in reverse. When goods and services become less popular their price will fall. This reduces the profit from producing such goods. Producers will therefore supply less, thus releasing resources for the production of other goods and services. A major advantage of the price mechanism is that it works automatically and does not require the vast bureaucracy that existed in centrally planned economies to allocate resources. Furthermore it ensures that the goods and services society demands are produced as efficiently and quickly as possible. If

WHAT IS ECONOMICS?

this were not the case, producers could improve their profits by increasing their efficiency. Clearly some of the problems of central planning can be overcome by allowing a greater role for the price mechanism in the allocation of resources. However this does not imply that a wholly free enterprise economy faces no problems. One problem is that, because production is undertaken for profit, environmental considerations might again be neglected. The deforestation of the Amazon and Asian jungles in the quest for profit has led to environmental pollution and serious upheaval for those tribal societies who depend on the forest for survival. Another problem with wholly free enterprise economies is that certain goods, known as demerit goods, will be produced when it is profitable to do so. An often quoted example is cigarettes. The illnesses cigarette smoking causes result in working days lost and this adversely affects the amount of goods and services the economy produces. In addition resources are used in the treatment of these illnesses which could be put to some alternative use if they were not required for health care. A major problem with wholly free enterprise economies is that goods and services will only be produced if they are profitable. However, some goods confer substantial benefits on society but, by their very nature, can never be profitable. Public goods such as lighthouses and street-lighting have two distinct characteristic features: they are non-rival and non-excludable. They are non-rival because consumption by one person does not reduce the amount available for consumption by another person, and they are non-excludable because once provided it is impossible to restrict consumption to particular groups. Because of this, no-one would ever pay individually for a public good and such goods can therefore never be profitable. In other words in a free enterprise economy they would not be provided. In addition merit goods, such as education and health care, which confer benefits on those who consume them and on society as a whole, would be underproduced in relation to the optimal level. In a wholly free enterprise economy, education and health care would only be provided for those who were prepared to pay. Inevitably some people would refuse to pay and in consequence would opt out of education and health care. Others would be unable

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to pay and some would economise on the amount they purchased. This would affect labour productivity because a healthy labour force loses fewer days through illness while a well-educated labour force is more adaptable to changes in demand or technology. The more productive the labour force the faster the standard of living improves. It is clear that some of the problems of centrally planned economies can be alleviated by allowing a greater role for the price mechanism in the allocation of resources. However wholly free enterprise economies also have problems and this is why most economies in the world are mixed, that is, they contain elements of the centrally planned and the free enterprise economies. 2 Opportunity cost is defined as the next most desired alternative forgone. The reason why an alternative is forgone is that the desires of society seem unlimited, while the ability to satisfy those desires is strictly limited by the availability of resources, the state of technology, the techniques of production, and so on. In other words resources are scarce and, since society cannot have all that it desires, it must choose which wants will be satisfied with its limited resources. Statement 1 is therefore correct. Resources can be used to produce a whole range of goods and services. For example, everything which society produces requires labour. Labour can therefore be used in a variety of alternative ways and the same is true of society's other resources. If resources were specific and could only produce one particular good, then the opportunity cost of production would be zero because no alternative would be forgone. Statement 2 is therefore correct Not all goods consumed by society have an opportunity cost. Some are what economists term free goods. Such goods do not require the input of scarce resources. The most often quoted example of a free good is fresh air, but other examples include sand in the desert and ice at the north pole. In both of these cases there is no opportunity cost of production and increased consumption by one person does not necessitate a cut in consumption by another person. Statement 3 is therefore incorrect. The key is B.

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INTRODUCTORY ECONOMICS COURSE COMPANION

REVIEW QUESTIONS AND ANSWERS

Questions 1 Why is the 'economic problem' a problem?

2 Is the problem of scarcity in the UK greater now than it was in 1970? 3 Apply the concept of opportunity cost to:

(a) A student who stays in full-time education after the age of sixteen. (b) A firm wruch borrows funds from a bank to buy a new machine. (c) A government wruch financies increased spending on road construction by an increase in taxation. (d) A home owner who carries out home improvements on a DIY basis in his or her spare time. 4 In what sense is the consumer sovereign in market economies? 5 In a market economy, how will the allocation of resources be affected by technological advances wruch significantly reduce the cost of producing a particular good? 6 What is 'mixed' in a mixed economy?

Answers 1 The economic problem is a problem because it implies unsatisfied desires which compels society to make choices. All goods and services are produced from scarce resources which have alternative uses. Society is therefore forced to choose what goods and services will be produced, how they will be produced and for whom they will be produced.

2 The problem of scarcity cannot be quantified but it seems likely that there are at least as many unsatisfied desires in the UK now as there were twenty years ago. Of course the standard of living

is higher, but in all societies, including the UK, it seems that as soon as one desire is satisfied another emerges. 3 (a) The opportunity cost of staying in education after the age of sixteen is the earnings forgone as a result of remaining in full time education. (b) The opportunity cost here is the rate of interest that could have been earned, for example if funds had been deposited in a bank. (c) In thls case the opportunity cost is equal to the output that would otherwise have been produced if additional roads were not constructed. Since the value of the output forgone is exactly equal to the amount that would have been spent on it, the opportunity cost of additional road construction is also equal to the additional amount paid in taxation as a result of the road construction programme. (d) The opportunity cost here is the alternative to which time might have been put. If the home owner would otherwise have done nothing, the opportunity cost would be nothlng. 4 The consumer is sovereign in the sense that it is decisions by the consumer wruch dictate the pattern of production in a market economy. After all, if consumers do not buy products, producers will make no profits. We can be certain therefore they will produce those goods and services wruch consumers most desire.

5 A reduction in the cost of producing a particular good will, under normal circumstances, lead to a reduction in the price of that product. This will encourage consumption and persuade producers to increase their output. 6 The ownersrup of resources is mixed in a mixed economy. Some are owned by private individuals, but others are owned by the state and controlled by the government. For example, in the UK television sets are produced by privately owned businesses whereas law and order is provided through the state.

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CHAPTE R 2

THE TOOL S OF ECO NOM IC ANA LYSI S

Topic

ifable 2.1

Summa~

1---

In this chapter we look briefly at the construction and interpretation of the different diagrammatic techniques most commonly used by economists.

M 2 3 4 5

Graphs Economists make great use of graphs to help interpret and illustrate economic data. A graph simply plots pairs of points or coordinates against a y axis (vertical axis) and an x axis (horizontal axis). Figure 2.1, which is derived from Table 2.1, illustrates a relationship between two variables, x and y. We can see from Table 2.1 that when y is 5 x is 40, and when y is 4 x is 50 and so on. Figure 2.1 simply plots the points given in Table 2.1. Graphs of this nature, as we shall see throughout this book, are widely used in economics.

Figw-e 2.1 A graph showing a linear relationship between x andy y 5

(~

80 70 60 50 40

Bar Charts Economists often use bar charts to illustrate data, particularly when making comparisons. For example, if we take a particular variable, let us call it y, we can use a bar chart to compare its value in different years and in different countries. Figure 2.2 which is based on Table 2.2, amply demonstrates the use of bar charts when making comparisons. We can see that in year 1, y was greatest in country A and lowest in country C. However, by the end of year 2 the situation had changed dramatically because of the growth of y in country C. Even a glance at Figure 2.2 makes the changes in the value of y between different countries clear.

4

Pie Charts

3 2

20

40

60

80

100

X

Another diagram frequently used by economists is the pie chart. This is simply a circle divided up into segments to illustrate the proportionate value of the component parts of a particular aggregate. However, unless each segment gives the proportion of each of the components, it is often difficult to identify the relative size of the different components. On the other hand, if the respective proportions are given,

8

INTRODUCTORY ECONOMICS COURSE COMPANION

Figure 2.2 A typical bar chart _ _ _ _ __.

Table 2.2 y

25

20

y

,....-

15

Year 1

Year 2

Country A

20

25

Country B

16

18

Country C

10

20

10

5

there seems little point in illustrating them in a pie chart! A pie chart is illustrated in Figure 2.3a on p. 9. Yr1 Yr2 Yr1 Yr2 Yr1 Yr2 Country A Country B Country C

REVIEW QUESTIONS AND ANSWERS

Questions 1 Rather than using models would it be better if economists studied the real world as it actually operates when formulating theories? 2 Devise (1) positive and (2) normative state-

ments about the following:

(a) The comparative earnings of nurses and pop stars. (b) The level of unemployment. (c) The rate of inflation. (d) The housing shortage (seep. 47).

3 'Figures from the Institute of Economic Affairs (1991) show that in 1985 the numbers of newly qualified craftsmen, technicians and graduate engineers and technologists in the UK were 35,000, 28,000 and 15,000 respectively. In France the corresponding figures were 92,000, 30,000 and 16,000, while in Germany the figures were 120,000, 43,000 and 22,000'. Summarise the statistical content of this quotation in tabular form, as a pie chart and as a bar chart. Which form is visually most effective?

Answers 1 Economists do study the real world when formulating theories! All theories in economics begin with an observation of some event which the theory attempts to explain. The problem is testing theories because in the real world variables which affect economic behaviour often change concurrently and it is therefore difficult to identify the precise effect of a change in any single variable. To some extent models overcome this problem because we can then assume all variables, except those we wish to alter, are constant. 2 (a) (i) Nurses are more important than pop stars and therefore should earn more. (ii) Those at the top of the earnings league in the nursing profession earn less than the most highly paid pop stars. (b) (i) A high level of unemployment is undesirable. (ii) Unemployment in the UK was over three million last year. (c) (i) The rate of inflation in the UK is too high. (ii) The UK has the lowest rate of inflation of any country in Europe.

9

THE TOOLS OF ECONOMIC ANALYSIS

(d) (i) Too many city centre properties have been converted into offices. (ii) The increasing number of homeless people in the UK is evidence of a growing housing shortage.

Figure 2.3b Newly qualifod craftsmen,

technicians, engineers and technologists 120

.....-

3 100

Table 2.3

,....--

Craftsmen

Technicians

Graduate engineers and technologlsts

UK

35000

28000

15000

France

92000

30000

16000

120000

3.000

22000

Germany

Source: lEA, 1991.

40

,....-,....--

20 ::..:

Figure 2.3a Newly quali_Md craftsmen, technicians, engineers and technologists

r

UK

Craftsmen 66.7%

France

Gennany

:::::l

.----.----

j (8f

Craftsmen

::..:

:::::l

i

u..

I gJ]

Technlclans

Engineers & Technologists

Which of the three statistical summaries is visually the most effective is a matter of opinion and partly depends on the purpose for which the data are to be used. Table 2.3 shows the actual numbers in each category, whereas Figure 2.3a shows the proportions in each category. For most people the relative size of each category is probably clearer in the bar chart.

10

CHAPTER 3

DEMAND, SUPPLY AND MARKET PRICE Figure 3.1 A cliiinge in quantity Oiiiiiinaeii

Topic Summary To economists the term demand has a specific meaning. It is more than simply the desire to consume goods and services; it is the desire to buy something, backed up by the willingness and ability to pay for it.

Price

Demand A Change in Quantity Demanded The basic law of demand is that for most goods and services the quantity demanded will vary inversely with price, that is, when price decreases, quantity demanded increases and vice versa. The operation of this law is easy to observe whether we consider the behaviour of an individual as the price of a good changes over a short period of time, or the quantity of a particular good or service demanded by all consumers as its price changes over a short period of time. Look at what happens during sale times, for example, when the prices of goods are marked down. But why do we stress the behaviour of demand over a short period of time? The answer is that this enables us to assume that all other influences which might affect demand are unchanged. In other words we can isolate the effects of price changes on quantity demanded. Figure 3.1 illustrates the basic relationship. It is extremely important that you use the correct terminology when discussing movements along a demand curve. In Figure 3.1 we refer to a movement along the demand curve from A to B as an increase in quantity demanded or an extension of demand, and a movement from B to A as a reduction in quantity demanded or a contraction of demand. More is said about these important terms on pp. 12-13.

A Change in Demand In our analysis above it was stressed that demand curves are drawn on the assumption that all influences on demand other than price are unchanged. These other influences which affect demand are usually referred to as the conditions of demand or the parameters of demand. A change in any of these conditions of demand will cause the entire demand curve to shift its position. In Figure 3.2 a shift in the demand curve from DD to D1D1 is Figure 3.2 A cliiinge tn D

01

Price

o, D Quantity

DEMAND, SUPPLY AND MARKET PRICE

referred to as an increase in demand and a shift in the demand curve from DD to D2D2 is referred to as

a decrease in demand.

11

unchanged. These other factors which affect supply are usually referred to as the conditions of supply or the parameters of supply. A change in any of these conditions of supply will cause the entire supply curve to shift its position. In Figure 3.4 a shift in the supply curve from to sl sl is referred to as an increase in supply and a shift in the supply curve from SS to 5 25 2 is referred to as a

ss

The basic law of supply is that for most goods and services the quantity supplied will vary directly with price, that is, when price per unit rises, quantity supplied falls and vice versa. There are two reasons for this. When price rises it becomes more profitable for those firms already producing the product to increase their output. Furthermore a rise in price encourages other firms to undertake production. For these reasons we find that more is supplied at a higher price than at a lower price, as Figure 3.3 shows.

decrease in supply.

Figure 3.4 A clulnge in supply

Price

A Change in Quantity Supplied We assume that all other things which might affect supply remain unchanged so that we can isolate the effects of price changes on quantity supplied, and again the same rules of terminology apply. A movement along the supply curve from A toBin Figure 3.3 is referred to as an increase in quantity supplied or an extension of supply, and a movement from B to A is referred to as a reduction in quantity supplied or a contraction of supply. More is said about these important terms on pp. 12-13.

A Change in Supply In our analysis above it was stressed that supply curves are drawn on the assumption that all influences which affect supply other than price are

Quantity

Equilibrium Price and Quantity In free markets prices are determined by the opposing forces of supply and demand and the equilibrium price and quantity exist when there is no tendency for price or quantity to change. In Figure 3.5, P is the equilibrium price and Q the equilibrium quantity. No other combination of price and quantity will be stable in this market.

Figure 3.5 The equilibrium price and quantity

s

Price

s

0

Price

Q

Quantity

12

INTRODUCTORY ECONOMICS COURSE COMPANION

At any price above P the quantity supplied will exceed the quantity demanded and price will fall. At any price below P quantity demanded will exceed quantity supplied and price will rise. Once equilibrium is established there can be no change in price or quantity unless there is a shift in the demand curve and/or a shift in the supply curve.

In this section we are concerned with four types of elasticity and the following symbols are used throughout: = =

P

=

Y

=

Cross elasticity of demand is a measure of the responsiveness of demand for one good to a change in the price of another good. It is calculated in the following way: ilQa xPb QaxMb

Elasticity

il Q

ilQx Y QxilY

---

change in quantity price income

In all cases, if the coefficient of elasticity is > 1, demand (supply) is said to be elastic; < 1, demand (supply) is said to be inelastic; = 1, demand (supply) is said to be in unity.

Common Mistakes to Avoid

Price elasticity of demand (usually referred to simply as elasticity of demand) is a measure of how responsive quantity demanded is to a change in price. It is calculated in the following way: ilQxP QxilP Elasticity of supply is a measure of how responsive quantity supplied is to a change in price. It is calculated in the following way: ilQxP QxM Income elasticity of demand is a measure of the responsiveness of demand to a change in income. It is calculated in the following way:

One of the most common mistakes made 1s to confuse movements along a demand curve with shifts of a demand curve. The difference is crucial because they each have different effects. The main point to remember is that demand curves are drawn on the assumption that all other things which affect demand, apart from price, are held constant. A movement along a demand curve can therefore only be caused by a change in supply, that is, a shift of the supply curve. Figure 3.6 illustrates this. In Figure 3.6a SS and DD are the original supply and demand curves for a given manufacturing product. The equilibrium price is P and the equilibrium quantity is Q. Subsequently an increase in costs of production shifts the supply curve to slsl. The new equilibrium position is established when price has increased to P 1 and the amount supplied and demanded has fallen to Q1. However the im-

Figure 3.6 The effect of (a) a decrease in supply, (b) an increase in demand (a)

s,

D

Price

s

D

Price

(b)

o,

P,

p, p

p

s,

o, D

o,

Q

Q

Quantity

o,

Quantity

DEMAND, SUPPLY AND MARKET PRICE

portant point to note is that there has been no change in the position of the demand curve. There has therefore been a movement along the original demand curve, and in this case quantity demanded has fallen by QQ1• A reduction in costs of production would have exactly the opposite effect and in this case there would be an increase in the quantity demanded. In Figure 3.6b, SS and DD are again the original supply and demand curves for a given manufacturing product, and P and Q are the equilibrium price and quantity. Subsequently an increase in income shifts the demand curve to D1D1. The new equilibrium position is established when price has increased to P 1 and the amount supplied and demanded has increased to Q1. In this case there has been an increase in demand and an increase in the quantity supplied. Notice that in both Figure 3.6a and 3.6b there has been an increase in price, but the effect on the equilibrium quantity is different because the cause of the price increase is different. A reduction in income has exactly the opposite effect. The important point to grasp is that it is necessary to understand the cause of a price change before we can predict its effects. Furthermore, having identified the cause, you must take great care to ensure you use the correct terms when explaining these effects.

Questions and Answers The data below give estimates of the elasticity of demand for selected foods in the UK. The figures in brackets are standard errors. Income elasticity of demand (1987) 0.10 0.26 -0.22 -0.43 0.95 -0.18

(0.03) (0.03) (0.08) (0.08) (0.18) (0.03)

Price elasticity of demand (1982-87) Beef and veal Bread Fresh potatoes Fruit juices Margarine

-1.24 - 0.25 -0.14 -0.65 -0.37

Cross elasticities of demand for beef and veal, and pork (1980-87) Elasticity of demand for Beef and veal Pork

With respect to the price of beef and veal pork -1.24 (0.26) 0.10 (0.10) 0.25 (0.25) -1.86 (0.22)

Source: 'Household Food Consumption Expenditure', Annual Report of the Food Survey Committee, 1987, HM:SO. 1 Explain the phrase 'The figures in brackets are standard errors'.

2 What is meant by the terms (a) income elasticity of demand, (b) price elasticity of demand, (c) cross elasticity of demand?

3 Are the estimates of elasticity given here consistent with conventional demand theory?

4 How might these estimates of elasticity be used

to predict future expenditure of consumers, and how accurate are these estimates likely to be?

Answers

Questions•

All foods: of which Beef and veal Margarine Fresh potatoes Fruit juices Bread

13

(0.26) (0.18) (0.03) (0.23) (0.23)

*The following questions and answers are taken from British Economy Survey, vol. 18, no. 2, Longman, 1989.

1 When statisticians calculate estimates of particular variables they also make predictions about how accurate these estimates are likely to be. The standard error of an estimate shows that there is only a 5 per cent probability, that is, a 1 in 20 chance, that the true value of the variable will not lie somewhere in the range given by its estimated value, plus or minus twice the standard error. Standard errors therefore provide a test on the reliability of statistical estimates. 2 (a) Income elasticity of demand for a good is a measure of the responsiveness of demand for that good to changes in income. It is usually measured by tile formula: !lQa...:... !lY = !lQaY Qa . Y !lYQa Where Qa is the amount demanded of good a, Y is income and !l refers to a change in the variable it prefixes. In general, the greater the income elasticity of demand for a good, the greater the change in demand for that good following a change in income. (b) Price elasticity of demand for a good is a measure of the responsiveness of quantity demanded

14

INTRODUCTORY ECONOMICS COURSE COMPANION

for that good to changes in its price. It is usually measured by the formula: AQa....:... APa = AQaPa Qa . Pa QaAPa

The variables are as previously defined with the exception of Pa which refers to the price of good a. In general, the greater the price elasticity of demand for a good, the greater the change in the quantity demanded of that good following a change in its price. (c) Cross price elasticity of demand for a good is a measure of the responsiveness of demand for that good, to a change in the price of another good. It is usually measured by the formula: AQa....:... APb=AQaPb Qa . Pb QaAPb

The variables are as previously defined. In general, the greater the cross price elasticity demand for a good, the greater the change in demand for that good following a change in the price of another good. 3 For all 'normal goods' the characteristic elasticity features are 'positive income elasticity of demand', and 'negative price elasticity of demand'. Not all of the goods listed in the table possess these characteristics. Normal goods have positive income elasticity of demand because, as income grows, more goods will tend to be demanded. However, in some cases, as income grows less of a particular good might be demanded. Such goods are referred to as 'inferior goods' since a rise in income persuades consumers to substitute more expensive goods for goods which have become cheaper in real terms because of the rise in income. Examples of such goods are bread, fresh potatoes and margarine. All three are often cited as examples of inferior goods and it is easy to see the kind of substitutions that might take place as incomes rise. For example, as incomes rise it is likely that prepacked potatoes will be substituted for fresh potatoes and so on. Normal goods also possess negative price elasticity of demand. This implies that as the price of a good rises there is a reduction in the quantity of that good demanded. This is one of the laws of demand and it is this basic proposition that enables us to draw normal demand curves. All of the goods given in the table possess this characteristic and therefore all would have been expected to have normal demand curves during the period covered by the data. In addition, the estimates of cross price elasticity of demand for beef and veal with respect to pork,

and vice versa, have the expected signs. Beef and veal might be considered substitutes for pork. Hence an increase in the price of beef and veal might be expected to cause an increase in demand for pork as consumers substitute pork for beef and veal. The income elasticity of demand for 'all food' is relatively low at 0.10 since much the same quantity of food will be consumed whether income rises or falls. It might be possible to economise on the consumption of food when income falls, by cutting down on waste for example, but there is unlikely to be great scope for economies here. Equally a rise in income is unlikely to lead to an increase in the consumption of food, at least in a developed economy such as the UK. It seems likely therefore that rather than aggregate consumption of food changing as income changes, total spending on food changes because more expensive or less expensive food is consumed in response to a change in income. The relatively low value of income elasticity of demand for beef and veal might seem somewhat surprising. It is possible that the income elasticity of demand for beef on its own would have a higher value since for many people on lower incomes beef is still something of a luxury good. As incomes rise such people will substitute beef, and probably to a lesser extent veal, for cheaper cuts of meat. Of the products for which we have data, fruit juices have the largest income elasticity of demand. The implication is that as income rises by 1 per cent, total spending on fruit juices increases by 0.95 per cent. This implies an income elasticity of demand of almost unity and undoubtedly reflects a growing preference for fruit juices as income rises, compared with other kinds of soft drink which tend to contain additives, some of which are thought to have undesirable side-effects. The price elasticity of demand for beef and veal is elastic, that is greater than 1. In such cases a change in price will lead to a more than proportional change in quantity demanded. With respect to beef and veal, one reason for this is that pork is perceived to be a substitute. Evidence of this is given in the data showing estimates of cross elasticity of demand for these products. All of the other foods on which we are given data are price inelastic, that is, a change in price leads to a less than proportional change in quantity demanded. The low price elasticities of demand for bread and fresh potatoes in particular stem largely from the fact that these foods are considered necessities. The demand for fruit juices is also inelastic with respect to price. Fruit juices might be less of a necessity than bread and fresh potatoes, but consumers clearly have

DEMAND, SUPPLY AND MARKET PRICE

a strong preference for them and the inelastic demand probably reflects a perceived absence of close substitutes on the part of consumers. In general, it is clear that the estimates of income elasticity and price elasticity that we are given are consistent with conventional economic theory. 4 The data we are given is useful in predicting future consumer expenditure. However, on its own it is not enough. We also require estimates of how prices and incomes are expected to change. Over relatively short periods this is not a problem, since likely changes in prices and incomes can be estimated from raw material price increases, the level of wage settlements, changes in productivity, and so on. Given estimates of these, the data can be used to predict future consumer expenditure on the products listed. For example, if the price of bread is expected to rise by 5 per cent and incomes are expected to rise by 2 per cent over some period of time, and all other things remained unchanged, total expenditure on bread would rise by approximately 1.82 per cent of its current level. This is because the rise in the price of bread will lead to a fill in consumption of 1.25 per cent. In other words, the reaction to the price change alone would be such that 98.75 per cent of the current amount of bread purchased would be bought as 105 per cent of its current price. Furthermore the rise in income would lead to a fall in consumption of bread of 0.18 per cent. Multiplying this out we have: 98.75

X

1.05

X

0.982

C::::

101.82

Given estimates of expected price changes for all goods it would be possible to predict expected future changes in consumer expenditure.

15

However, these predictions might not be entirely accurate. The values calculated for both income and price elasticities of demand are based on past trends, and this is not always a sound basis on which to make future predictions. There might be changes in tastes, or the emergence of new products which will influence expenditure patterns. For example, growing concern about the relationship between health and diet has exerted a powerful influence on the consumption of certain foodstuffs. In other words, future predictions are based on the assumption that all things remain equal. If they do not, predictions of future consumption expenditure will be less reliable. Additionally, the estimates of elasticity might themselves be subject to a wide margin of error. Elasticity is an extremely difficult concept to measure. For example, if we attempt to measure price elasticity of demand for a commodity, it might be possible to observe a change in the price of that commodity and, in the following period, a change in the amount purchased. However, this does not necessarily imply a change in the quantity demanded unless we are certain that nothing other than price has changed. In the real world it is almost impossible to be completely certain that this is the case. Similar problems are apparent in the measurement of income elasticity of demand. If the estimates of elasticity are not accurate, predictions of future consumer expenditure derived from these will not be accurate. A final problem is that estimates of price and income changes might not be accurate. This is especially likely when estimates refer to a longer time period. The shorter the time period to which estimates refer the greater their accuracy. Again if estimates of future changes in prices and incomes are not accurate, predictions based on them will not be

accurate.

16

INTRODUCTORY ECONOMICS COURSE COMPANION

REVIEW QUESTIONS AND ANSWERS (i)

Questions 1 Consider the following supply and demand schedules:

The supply of and demand for lettuces in Borchester during August

Price (p) 48 40 32

24

16

8

Quantity demanded 1000 3600 6000 8000 10000 14000

Quantity supplied 16000 12600 10000 6000 4000 2500

On graph paper, plot the supply and demand curves associated with these schedules, then answer the following: (a) If market price were at a level of 40p, what would you expect to happen to price, and why? (b) If market price were at a level of 16p, what would you expect to happen to price, and why? (c) At what price would you expect the market to eventually settle, and why?

2 Use supply and demand analysis to predict the likely changes in the price and quantity of:

(a) tinned peaches after an increase in the price of tinned apricots; (b) cream when there is a large fall in the price of strawberries; (c) butter following publicity that consuming butter adversely affects health; (d) beef following an epidemic which kills cattle; (e) butter following a large increase in the price of cheese; (f) flowers on the day before Mother's Day; (g) ice cream during a hot summer; (h) lamb when the price of wool rises considerably;

cheese following an increase in the wages of dairy workers.

3 Why is a second-hand book generally cheaper than a brand new copy? Under what circumstances might a second-band book attract a substantially higher price than a new one?

4 'An increase in price reduces quantity de-

manded, while a fall in demand reduces price.'

A non-economist might find this statement contradictory. By distinguishing between shifts of a demand curve and movements along a demand curve, explain the apparent contradiction.

5 Consider the following demand schedule:

Price (pence) 3 5 6

Quantity (units) 100 50 30

Calculate the price elasticity of demand for a change in price from: (a) (b) (c) (d) (e) (f)

3p 5p 5p 6p 3p 6p

to to to to to to

5p; 3p; 6p; 5p; 6p; 3p.

Comment on your results. 6 A demand curve makes a parallel shift to the right. Has price elasticity of demand increased or decreased at each price? Explain your answer. 7 The Chancellor of the Exchequer is advised that the price elasticity of demand for milk is 1.2 for low income groups and 0.23 for high income groups. Why might this information help to lead to the conclusion that milk is a suitable item to be subsidised by the government?

DEMAND , SUPPLY AND MARKET PRICE

Answers 1 Figure 3.7 Supply and demand for lettuce in Borchester during August

s

Price 40

30 20 10

s 2000 4000 6000 8000 10 000 12 000 14 000 Quantity supplied and demand

(a) At a price of £0.40 supply exceeds demand and therefore the price of lettuce would fall. (b) At a price of £0.16 demand exceeds supply and therefore the price of lettuce would rise. (c) We are given insufficient information to enable us to determine precisely what the equilibrium price will be in this market, but the supply and demand schedules shown in Figure 3.7 suggest that a reasonable approximation would be £0.27. Why? Because at this price supply of lettuce during August equals demand for lettuce during August equals 7200 heads (approximately).

2 Before we can predict the effect of any price change we must identify its cause. In some of the sub-sections of question 2 there are several possibilities depending on what assumptions we make about the cause of the initial price change. In each case it is necessary to assume that all other things remain equal. With these points in mind let us consider some of the alternatives. (a) Assume the increase in the price of tinned apricots is caused by a reduction in supply. As the price of tinned apricots rises there will be a reduction in quantity demanded and consumers will increase their demand for substitutes such as tinned peaches. As demand for tinned peaches rises, the price of tinned peaches will rise. (b) Assume the decrease in the price of strawberries is caused by an increase in supply. As the price of strawberries falls, the quantity demanded

will increase. Since strawberries and cream are jointly consumed, there will be an increase in the demand for cream and therefore the price of cream will rise. (c) The demand for butter will fall and this will cause a reduction in the price of butter. (d) The supply of beef will fall and therefore the price of beef will rise. (e) Assume the increase in the price of cheese is caused by an increase in demand for cheese. The rise in the price of cheese will encourage an increase in production. Since milk and cheese are both produced from milk, it is possible, that as more milk is devoted to cheese production, less will be available for butter production. As the supply of butter falls the price of butter will rise. (f) The demand for flowers will increase and therefore the price of flowers will rise. (g) The demand for ice cream will increase and therefore the price of ice cream will rise. (h) Assume the increase in the price of wool is caused by an increase in the demand for wool. As the price of wool rises, farmers will send fewer lambs for slaughter and therefore the supply of lamb will fall. In consequence the price of lamb will rise. (i) An increase in the wages of dairy workers will increase the cost of producing cheese and this implies a reduction in the supply of cheese. In consequence the price of cheese will rise. 3 At any given price consumers will, in general, prefer new books to secondhand books. This implies a greater demand at any given price for new books and this is the main factor explaining the higher price of new books compared to secondhand books. However, in some cases, books become collectors items, especially first editions. In such cases, the limited supply, coupled with the relatively high demand, results in secondhand books commanding a higher price than the most recent edition of the same book on sale in a book shop. 4 This apparent paradox is easily explained using Figure 3.8. Remember, a change in quantity demanded implies a movement along an existing demand curve while a change in demand implies a shift of the demand curve. A change in quantity demanded can only be caused by a change in supply. In this case there is a reduction in

17

18

INTRODUCTORY ECONOMICS COURSE COMPANION

;:;__ _ _ _ _ _ _ _""'l nd .:..:::...;. ema in:....:d::;..:.;. Figure 3.8 The effect of (a) a reduction in supply, (b) a reduction .::.. (a)

(b)

s,

D Price

s

o,

Price

D

p

P, p

P,

s,

o, o,

Q

quantity demanded and therefore there has been a reduction in supply. This is illustrated in Figure 3.8a. SS is the original supply curve and DD the original demand curve, and P is the original equilibrium price. A reduction in supply shifts the supply curve SS to S1S1 and as price rises, there is a reduction in quantity demanded. The new equilibrium price is P1. A change in demand can only be caused by a change in at least one of the conditions of demand. In Figure 3.8b, DD and SS are the original supply and demand curves and the equilibrium price is again P. A fall in demand implies a shift of the whole demand curve closer to the origin, illustrated in this case by a shift to D1 ~. The result is a reduction in the equilibrium price to P1.

5 The relevant elasticities of demand can be calculated by substituting in the formula ED= AQ/QxPfllP. (a) Ed = 0.75 (b) Ed = 2.5 (c) Ed = 2.0

(d) Ed = 4.0 (e) Ed = 0.7 (f) Ed = 4.67

o,

Quantity

Q

D

Quantity

Comments (i) For a given price change, elasticity of demand is different if we consider a price fall rather than a price rise. (ii) Elasticity of demand varies along the entire length of the demand curve, being more elastic at higher prices than at lower prices for any given price change. There are only three exceptions to this rule, viz. when elasticity of demand is equal to zero, one or infinity. (iii) When elasticity of demand is elastic, that is, greater than 1, a price rise leads to a reduction in total revenue and a reduction in price leads to a rise in total revenue. When elasticity of demand is inelastic a price rise leads to a rise in total revenue and a reduction in price leads to a reduction in total revenue.

6 When a demand curve makes a parallel shift to the right, elasticity of demand decreases at ea.ch and every price because any given change in pnce will now be associated with a smaller proportionate change in quantity demanded. 7 Given these elasticity conditions, a subsidy might be justified on grounds of equity beca~se if, as seems likely, the subsidy leads to a reductiOn in price, lower income groups will increase their consumption of milk by proportionately more than higher income groups.

19

CHAPTER 4

THE PRICE MECHAN ISM AND MARKET FAILURE

Topic Summary In market economies resources are allocated through the price mechanism and the basic functions of price are to ration and inform. The rationing function is easy to understand. In market economies the problem of deciding how to allocate output to ultimate consumers is solved by allowing those who are willing and able to pay the market price to receive that output. Those unable or unwilling to pay receive nothing. To understand how price informs it is useful to look at the way price mechanism works. Consider the market for a particular good, good X. Now if society's preferences change in favour of good X compared to other goods, the demand for good X will increase and (in most cases) so will the price of X. The increase in price therefore informs producers of a change in society's preferences. In response, firms will increase their output of good X because the higher price increases the profit available from producing X. A change in society's preferences away from good X would have exactly the opposite effect and would be quickly communicated to producers by a reduction in the price of good X. Similarly a change in the conditions of supply would be quickly communicated to consumers of good X. For example, if technological progress makes possible the development of new and more productive machinery, the cost of producing good X will fall. At any given price, more will therefore be supplied than previously and we know from pp. 1213 that this will cause a reduction in the price of good X. This price reduction informs consumers of the changed conditions in the market for good X. The opposite happens if there is a reduction in the supply of good X.

An Optimal Allocation of Resources When economists use the term allocation of resources they are simply referring to the allocation of resources to the different goods and services which society produces. An optimal, or economically efficient allocation of resources is said to exist when it is impossible to make one member of society better off without making at least one other member of society worse off by a reallocation of resources: in other words, by changing the quantities of the different goods and services produced. It is often claimed that the free operation of the price mechanism will automatically lead to an optimal allocation of resources. The reasoning behind this view is simple. It is argued that price reflects the value consumers place on the last unit of a good they consume. It is further argued that price reflects the opportunity cost of producing the last unit because it reflects the additional cost the firm must pay to attract resources away from alternatives. Resources are allocated in the most efficient way when the value consumers place on the last unit they consume exactly equals the opportunity cost of production. Figure 4.1 is used to illustrate this point. In Figure 4.1, SS and DD are the free market supply and demand schedules for a particular good and P is the equilibrium price. If the government fixed price above P there would be an inefficient allocation of resources because, at any price above P, consumers value additional units of this commodity more highly than they value additional units of alternative commodities. This must be so because they are prepared to pay an amount for additional units of this commodity that is greater than the amount necessary to attract resources away from

20

INTRODUCTORY ECONOMICS COURSE COMPANION

Figure 4.1 Free market equilibrium and efficiency in th£ allocation of resources

- - - - - --t

s

D

Price

s

D Q

Quantity

resources in an optimal way. There are various reasons why markets might fail.

Externalities Externalities are the effects of production or consumption which fall on members of society other than the producer or consumer of some good or service. For example, if one person regularly smokes cigarettes in a room with non-smokers, the health of these non-smokers will be adversely affected because of passive smoking. The importance of externalities is discussed in the answer to question 1 on pp. 21-3. See also the next sub-section.

Merit Goods and Demerit Goods alternatives. Similarly, if the government fixed price below P, there would be an inefficient allocation of resources because, at any price less than P, consumers value additional units of alternative goods more highly than the last unit of this commodity consumed. This must be so because the amount they pay for the last unit they consume is less than the cost of attracting resources away from alternatives. Despite the appealing logic of this argument one point must be stressed. The allocation of resources through the price mechanism partly depends on the distribution of income. If we change the distribution of income we will change the allocation of resources. If we argue that the operation of the price mechanism leads to an optimal allocation of resources we must assume that the distribution of income is also optimal. Given the differing views of society on the importance of equity this is quite an assumption! Nevertheless it is clear from Figure 4.1 that at prices above P there is a market shortage of the commodity and when price is below P there is a market surplus of the commodity. In a free market shortages and surpluses are not sustainable. A surplus would lead to a fall in price until equilibrium is reached. In Figure 4.1, price will converge on P and at this point resources will be allocated in an optimal way because the value society places on the last unit of this product exactly equals its opportunity cost of production.

Market Failure Market failure is the term used to describe the circumstances when free markets fail to allocate

Merit goods are so called because they confer positive externalities on society. However, because free market prices do not include the effects of externalities, market prices would be greater than if prices did include the effects of positive externalities. Because of this, merit goods would be underprovided in relation to the optimum amount if they were supplied through the market. The most often quoted examples of merit goods are education and health care, which confer benefits on society as well as on those who consume them. (See the discussion of 'Common mistakes to avoid' below.) Demerit goods are exactly the opposite. They confer negative externalities on society and would be overconsumed in relation to the optimum amount if they were provided through the market. An often quoted example is cigarette smoking.

Public Goods Public goods confer benefits on society, but because of their characteristics they could never be provided through the market. The reasons for this are discussed in the answer to question 3 on p. 24. However it is important to realise that the absence of these goods is another source of market failure.

Monopoly The existence of monopoly, that is, a single supplier of a product, can cause markets to fail because a monopolist can restrict the amount of a product available for sale. Why this causes market failure is discussed on pp. 60-1.

THE PRICE MECHANISM AND MARKET FAILURE

Common Mistakes to Avoid Private Costs, Externalities and Social Costs The private cost of producing any good or service is simply the money cost of production. It therefore consists of such items as the cost of raw materials, labour, power to drive machinery and so on. However, acts of production or consumption sometimes generate externalities or spillover effects. When the value of these externalities is added to the private cost of production we have the full social cost of production.

21

AEB June 1990 3 A pure public good is one which 1 2

3

if consumed by one person does not reduce the amount available for others cannot be restricted in use to those willing to pay for it can be efficiently provided by the market mechanisms

A 1, 2 and 3 are correct B 1 and 2 only are correct C 2 and 3 only are correct D 1 only is correct E 3 only is correct ULEAC, January 1990

Public Goods and Merit Goods Public goods are often confused with merit goods. Both confer positive externalities on the community and would therefore be underconsumed in relation to the optimal level if they were provided through the market. However, as we shall see in the answer to question 3 below, public goods have particular characteristics such that no individual consumer would ever pay for them. Because of this, public goods would never be provided through the market, that is, by the private sector. Merit goods, on the other hand, do not have these special characteristics and could therefore be provided through the market. However certain merit goods such as education up to age 18 and health care are provided free of charge to consumers in the UK because of the importance of the externalities associated with consumption of these goods.

Questions and Answers Questions 1 Explain the terms 'external costs' and 'external (30) benefits'. Examine the relevance of these concepts when considering a proposal to build a nuclear power (70) station. ULEAC, June 1989 2 (a) Explain why the emission of pollution by a firm into the atmosphere or into a river may (13) be economically inefficient. (b) Evaluate two ways of reducing any econom(12) ic inefficiency caused by pollution.

Answers 1 Externalities are costs or benefits which stem from the activities of one individual or organisation but which affect other individuals or organisations who are not directly part of the original activity. In this sense externalities are the spillover effects of production or consumption. An often quoted example of an external cost occurs when a chemical factory dumps its waste products into a river. As a result of toxic contamination fish in the river die and those who fish down river from the chemical plant are therefore denied an amenity they previously utilised. If the chemical producer were compelled to treat waste materials before discharging them into the river, the cost of producing chemicals would rise. Instead the chemical producer treats the river as a free resource and in consequence transfers part of the cost of chemical production to anglers who used to fish the river. Externalities can often confer benefits on third parties. For example, individuals who vaccinate themselves against a contagious disease not only benefit themselves by eliminating the risk that they will catch the disease, they also confer a benefit on society since the risk that they will pass the disease on to others is also eliminated. Society benefits because there will be fewer working days lost through illness and costs of treatment will be avoided. The existence of these externalities has implications for the allocation of resources in an economy. It is sometimes argued that the free operation of market forces will lead to an optimal allocation of resources. The reasoning behind this view is that price reflects the value consumers place on the last

22

INTRODUCTORY ECONOMICS COURSE COMPANION

unit of a good they consume. But price also reflects the opportunity cost of producing the last unit because it reflects the additional cost the firm must pay to attract resources away from alternatives. Resources are allocated in the most efficient way when the value consumers place on the last unit they consume exactly equals its opportunity cost of production. Despite this, the existence of externalities can prevent free markets from achieving an optimal allocation of resources, as Figures 4.2 and 4.3 show. In Figure 4.2 the demand curve DD reflects only the private benefits from consuming nuclear energy and the supply curve SS reflects only private costs of producing nuclear energy. If it included external benefits the demand curve would shift upwards to the right, for example to D1D1 and the equilibrium price would then increase to P 1. This implies a completely different allocation of resources, since consumers demand more of this commodity and prefer more resources to be competed away from alternatives. In a free market there would therefore be underconsumption of this commodity in relation to the optimum level. In the case of a nuclear power station there are several positive externalities to consider and therefore the appropriate demand curve for nuclear energy is D1D1. A major benefit of constructing a nuclear power station is that it will create employment in the area where it is located. Construction workers will be required to build the power station, but even after completion it will provide employment because workers will be required to maintain and operate it. This will benefit the local economy generally as incomes rise and are (partly) spent in the local economy. Figure 4.2 Social benefits from consumption greater than private benefits from consumption, that is, positive externalities from consumption

Price

0 P, 1------'""'"-~ p 1------311(

0

Quantity

Once the power station is operational its benefits to society will be more widespread. A major benefit here is that greater reliance on nuclear power will reduce dependence on non-renewable sources of energy. In particular, coal-fired power stations have been major contributors to acid rain and global warming. Both of these impose costs on society. For example, acid rain is a major cause of dead lakes so that the social and recreational value of a lake is considerably diminished to users. However, global warming is potentially an even more serious problem and power stations which burn fossil fuels are the major UK contributor to global warming. The creation of nuclear power stations might therefore make a significant contribution to reducing environmental damage caused by burning fossil fuels. Another benefit of creating nuclear power stations is that the cost of generating electricity is considerably less than that of generating electricity using fossil fuels. This would directly benefit all users of electricity since it implies lower energy prices. However there would also be an indirect benefit to society because lower energy prices imply lower input costs for industry and this might make a minor contribution to lowering inflation. However, there are also potentially significant external costs associated with the generation of nuclear energy. In particular there are serious environmental and health risks to those who work in the power station or live in its vicinity. More generally in the case of a nuclear leak, radiation can contaminate vast areas, as the Chernobyl disaster of the 1980s demonstrated. In such cases whole communities might need to be evacuated and rehoused. Land that once provided food and recreation ceases to be available for these purposes, in some cases for many years. In the case of a nuclear accident, the cost of treating those unfortunate enough to suffer ill health are borne by society rather than being confined to those who generate electricity. The same is true of the cost of cleaning up the environment - where this is possible! Such cleaning up operations are financed by the taxpayer generally and can be relatively high. The loss of output due to illness imposes another cost on society. There are similar problems associated with the disposal of nuclear waste and with decommissioning a nuclear power station. Again we can illustrate the effect of negative externalities on the allocation of resources diagrammatically, as in Figure 4.3. In Figure 4.3 the supply curve SS reflects only private costs of production. If it included the cost of externalities it would shift upwards to the left, for example to sl sl and the equilibrium price would

23

THE PRICE MECHANISM AND MARKET FAILURE

The social cost of production greater

Figure 4.3

than private costs of production, that is, negative externalities in production

Figure 4.4 The effect of placing a unit tax on a product to achieve optimal resource allocation

s,

5, 5

Price

5

Price

P,

P,

p

p

s,

5,

0

0

a, a

Quantity

then increase to P 1. Again this implies a different allocation of resources, since consumers demand less of this commodity and prefer resources to be used in the production of alternatives. In a free market there would therefore be overconsumption of this commodity in relation to the optimal level. In the main the external costs associated with nuclear power generation are all potential costs. Nevertheless opting to generate more nuclear power is a high risk strategy and one which society favours less and less. 2 (a) The answer to part (a) of Question 2 requires a discussion of why the existence of negative externalities can lead to an economically inefficient allocation of resources and has been discussed in the answer to Question 1 above. (b) One way of reducing economic inefficiency caused by pollution is to tax the polluter in proportion to the amount of pollution generated. If we take the example of a factory which emits smoke pollution as a result of producing good X, those living in the vicinity of the factory experience a negative externality because the air around the factory is now polluted. The problem is illustrated in Figure

4.4.

DD is the demand for good X and SS is the supply curve when only private costs of production are considered. If this market was free of any government interference, the equilibrium price would be P and the equilibrium quantity Q. However, if S1 S1 is the supply curve when the effect of pollution is considered then the economically efficient level of output is Q1• One way of ensuring this level of output is produced is to place a tax on each unit of

a, a

Quantity

X produced which is equal to the cost of the negative externality generated in production. In this case, if a tax per unit of AB is placed on the production of good X the economically efficient level of output will fall to Ql. This approach to pollution regulation has much to commend it. Since the tax is levied on the amount of pollution generated, polluters have a clear incentive to cut down on the amount of pollution they generate by investing in cleaner technologies. Such a system of control is also relatively easy to administer. Firms simply pay a fee for each unit of pollution they discharge into the atmosphere. The difficulty, of course, is quantifying the cost of pollution and deciding on the appropriate rate of taxation. To achieve an economically efficient allocation of resources it is necessary to identify precisely the value of an externality. Economists are aware that it is extremely difficult to obtain an accurate evaluation of an externality, since those consulted might have a vested interest in overestimating or underestimating the value of the externality. Levying a tax which exceeds the value of the externality might lead to an allocation of resources which is inferior to that achieved by the market. A different approach to the problem of pollution control is to place a limit on the amount of pollution a firm is allowed to emit. However here again, unless we know the precise value of the externality imposed on the community (and the community's demand for the product) there is no way of knowing what the economically efficient level of output is, and therefore what limit should be placed on the quantity of the product produced. If the limit is set too low, again it

24

INTRODUCTORY ECONOMICS COURSE COMPANION

is possible that the allocation of resources will be inferior to the allocation achieved by the free market. However there are other problems with restricting the amount of output produced. In practice it is extremely difficult to monitor the regulations and there is likely to be widespread evasion, especially if the penalties are relatively low or if there is little risk of detection. Another problem is that limits on pollution usually apply equally to all firms. This does not necessarily encourage efficiency in the allocation of resources because uniform limits might not give firms an incentive to develop cleaner technologies. It would be more efficient if those firms which could reduce pollution at a lower cost than other firms were assigned a lower pollution limit. This would provide low cost firms with an incentive to cut pollution because they would otherwise be compelled to cut their output and therefore their profits would fall. However, such an approach requires an accurate assessment of which firms have the lowest cost of reducing pollution. This would be very difficult to estimate since the most efficient firms have an obvious incentive to conceal their true level of efficiency. In any case, variable limits would be regarded as unfair and would almost certainly be resisted by industry.

3 Pure public goods have two characteristics: they are non-rival in consumption and they are nonexcludable. A good is non-rival when consumption by one person does not diminish the amount available for consumption by another person. An often quoted example is a lighthouse. Once constructed, a lighthouse can be used as a navigational aid by a ship's captain without diminishing its usefulness to others. Option 1 is therefore correct. A good is non-excludable when it is either impossible or too expensive to prevent someone from consuming it. Again, if a lighthouse is constructed, it is impossible to prevent ships from using it as a navigational aid. Option 2 is therefore correct. Because public goods are non-rival in consumption and non-excludable it is impossible to levy a charge for them. Who would pay to consume a public good when the amount available does not diminish with use, and non-payers cannot be prevented from consuming it? Of course no-one would pay individually for such a good and therefore in a free market firms would receive no revenue if they produced it. Because of this, public goods can never be provided through the market mechanism. Option 3 is therefore incorrect. The key is therefore B.

REVIEW QUESTIONS AND ANSWERS

Questions Give some examples of circumstances where 'rotas' and 'lotteries' are used to ration scarce resources. 2 Why do universities and other higher education institutions insist on certain 'A' level grades as an entry requirement? Could the student loan scheme be described as a movement towards using the price mechanism? 3 Examine the arguments for and against the use of the price mechanism as a means of overcoming traffic congestion at places such as the Severn Bridge.

4 During the Christmas shopping period of 1989 British Rail received some criticism when it increased its fares into certain cities on Saturday mornings in order to reduce overcrowding on trains. In what ways could this policy be criticised, and are these criticisms justified?

Figure 4.5 Supply and demand conditions for car parking in a busy town centre Price (lee) per hour 6-

s

s4321-

0

100 200

D

aOO

400

sOO

Quanti1y of par1

t!

Ps

G> a:

- - A£1A_ - - - - -

Quantity

~ ~

!c:

! a:

~

ARA+B

MCA+B

PRICE DISCRIMINATION

them at a price below the current market price. His offence was to breach the practice of price discrimination. (a) Explain what price discrimination is and the circumstances necessary for it to be both (10) successful and profitable. (b) How did the actions of the Japanese businessman affect the practice of price (5) discrimination? (c) Who benefits and who loses as a result of the actions of the Japanese businessman? (10) UCLES, November 1991 2 Which of the following is an example of price discrimination? (1) A reduction at the turnstile for a child to

(2)

(3) (A) (B) (C) (D) (E)

watch a football match compared with the entrance fee paid by an adult. Bulk discounts on purchases of goods compared with the price paid for small amounts. A seat in a second-class compartment of a train compared with a seat in a first-class compartment. 1, 2 and 3 1 and 2 only 2 and 3 only 1 only 3 only.

Answers 1 (a) Price discrimination exists when consumers in different markets are charged different prices for the same product. However not all cases of such differential pricing are examples of price discrimination. Suppliers might charge different prices when there are differences in the cost of supplying different consumers. In these circumstances there is no discrimination because it is the motive behind price differences that determines whether discrimination is taking place. In short, price discrimination exists when suppliers are charging different prices simply to increase profits. Price discrimination is only possible when separate markets exist for a product, when different classes of consumer are charged different prices for a product, or where individual consumers are prepared to pay different prices per unit for different amounts of a product. For price discrimination to be possible three conditions must be satisfied:

• • •

69

supply of the product must be controlled by a monopolist; there must be separate markets and the monopolist must possess knowledge of the demand for the product in different markets; resale of the product must be impossible.

Control of supply by a monopolist is essential because, if there are many suppliers of the product, competition among firms will prevent price discrimination. Furthermore knowledge of consumer demand is necessary, otherwise the monopolist will be unaware of the opportunity for price discrimination. Finally it must be impossible for consumers to buy the product at the lower price and then resell to other consumers who pay the higher price. The conditions above make price discrimination possible but they do not necessarily imply that price discrimination will be profitable. Price discrimination will always be profitable when an individual consumer is prepared to pay different prices for the product because the monopolist will be able to reduce consumer surplus. However, when there are different markets, price discrimination can only be profitable if the elasticity of demand for the product is different in each market. If elasticity of demand was identical at each and every price, marginal revenue would be identical at each and every price and, because profit maximisation implies that marginal cost is equated with marginal revenue, the monopolist would maximise profits by charging a common price. (b) It is not clear from the example we are given why the Japanese businessman was guilty of any kind of discrimination. By buying in one market and selling in another he acted more as an arbitrageur than one guilty of price discrimination. We are not told that he charged different consumers different prices. The implication is that, having purchased the product, he sold this in a single market at a uniform price. The fact that the price he charged was below the current market price is not discrimination! Nevertheless the information we are given does contain evidence of price discrimination. We are told that the businessman bought a Japanese product in Taiwan that had been exported at a price below the current market price in the Japanese market. If this were not the case, how could the businessman undercut the price charged for the product in the Japanese market? It would seem that the exporting firm, by charging higher prices in the domestic market, was guilty of price discrimination rather than the businessman. However, even here we cannot be certain. It is possible that domestic sales

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INTRODUCTORY ECONOMICS COURSE COMPANION

are subject to some form of taxation from which exports are exempt. This would explain why it was cheaper to buy abroad. In these circumstances the businessman's actions might be regarded as unfair competition. (c) One obvious gainer from the actions of the Japanese businessman is the businessman himself! There are costs involved in his actions, in particular the cost of purchasing goods in Taiwan and shipping them to Japan. For this to be profitable the businessman must be able to sell at a profit in the Japanese market. A section of Japanese consumers also gain because of the businessman's action. Those consumers who buy from the Japanese businessman are able to obtain at a lower price a product from abroad which is identical to that produced for the domestic market. This clearly improves the standard of living of those consumers who purchase the good imported from Taiwan because it implies that they are able to increase their total utility. The economy of Taiwan also gains because of the businessman's actions. By re-exporting to Japan they add value to the product they import and this has a favourable effect on the balance of payments. It also creates employment in Taiwan and no doubt adds to government revenue through increased tax yields. There are also losers from the businessman's action. The Japanese manufacturing firm loses sales in the domestic market. Clearly demand for the product exceeds the amount supplied by domestic

sources at the existing price. It is therefore reasonable to assume that many consumers who purchase the good imported from Taiwan would purchase from a domestic supplier if the imported substitute were not available. If Japanese manufacturers are selling to Taiwan at lower prices than they are offering in the domestic market, then the lost sales to imports from Taiwan imply lower sales revenue and lower profits for domestic suppliers than would otherwise be earned. Just as the actions of the businessman might benefit the economy of Taiwan there will be a reciprocal loss to the Japanese economy. The value added in Taiwan implies an increase in net imports which adversely affects the Japanese balance of payments. Similarly lower sales from domestic suppliers might adversely affect employment in Japan and imply lost tax revenue to the Japanese government. 2 Price discrimination occurs when consumers pay different prices for the same product or when the same consumer pays different prices for the same product. Option 1 is correct because different consumers pay different prices for the same product. Option 2 is also correct. In this case either different consumers, or the same consumer, will pay different prices for the same good depending on the amount bought. However, option 3 is clearly incorrect. In this case different consumers purchase a different product. The key is B.

REVIEW QUESTIONS AND ANSWERS 1 Consider whether or not each of the following is a case of price discrimination. Give your reasons in each case, and for each instance of price discrimination, state how the conditions (such as avoiding separation between mar· kets) have been achieved: (a) The Ford Motor Company offers a fleet of Ford Fiestas to the British School of Motoring at a substantial discount. (b) Industrial users of electricity are charged a different price to domestic users.

(c) Business travellers flying from London to Madrid by scheduled air services pay higher prices than holidaymakers on a package deal. (d) A concert is advertised with seats at no fewer than nine different prices. (e) Surplus butter from the EC is sold cheaply to Russia, and is given away to British senior citizens. (f) Parents pay different contributions towards their children's university education, depending on income.

PRICE DISCRIMINATION

Question 2 is based on the following article:

A Large Beef About Oxo Are you paying too much for Oxo cubes? It has come out in a court case that Brooke Bond's export price for Oxo cubes is 42 per cent cheaper than shops in Britain pay. On the face it that should mean that a packet of Oxo selling at around 38p in your local shop should cost only 22p. Brooke Bond could not explain its double pricing because all its experts are busy giving evidence at the trial. The defendants are accused of trying to buy Oxo at the cheaper export price in order to sell it in Britain at a profit. Surely the real crime is that firms operate such two-faced pricing systems in the first place. I look forward to hearing Brooke Bond's explanation when its experts can spare me the time.

Source: Daily Mirror (28 October 1987). (a) How does your knowledge of price discrimination enable you to analyse the behaviour of Brooke Bond with respect to the pricing of Oxo cubes? (b) One of the conditions for price discrimination to exist is a 'separation of markets' with no 'seepage' between markets. (i) Explain how this condition seems to have broken down in the Oxo case. (ii) Would you agree that the continuation of price discrimination partly depends on consumer ignorance? (iii) Suggest why the company appears to be willing to go to the expense of a court case in order to tnaintain separate markets. (c) Apart from the condition referred to in (b), how are the other conditions for price discrimination likely to apply to Oxo? (d) What possible reasons might Brooke Bond put forward to try to justify their pricing policy, and how might these differ from an economist's analysis of the tnatter?

71

Answers 1 (a) Discounts offered for bulk purchases are an example of price discrimination. One buyer obtains the product at a lower average price than another buyer. (b) This is another example of price discrimination. Different buyers purchase an identical product but pay different prices. (c) This is not price discrimination. Scheduled flights have preference over package flights in terms of flight departures (delays on package flights are frequent and often lengthy) and in terms of in-flight provisions for passengers. (d) Whether this is price discrimination or not depends on why different prices are charged. If different prices are charged for different seats there is no discrimination. On the other hand, if different prices reflect concessions made to different groups such as pensioners, the unemployed and students, this is clearly price discrimination. (e) This is clearly a case of price discrimination because purchasers in the EC pay a higher price than Russian consumers and British senior citizens, who receive butter free of charge. (f) If parents are required to pay a portion of their son's or daughter's university fees which is related to their income, this would indeed be price discrimination because parents would effectively be charged a different price for their son's or daughter's university education. However at present this does not happen in the UK. At present parents with a relatively high combined income simply have responsibility for making a contribution towards their child's grant. This is not price discrimination because in this case parents are not purchasing anything. 2 (a) Brooke Bond are selling Oxo cubes in the domestic market at a higher price than consumers pay abroad. The aim is probably to increase profits and the higher price in the domestic market probably reflects a lower elasticity of demand than in export markets. (b) (i) The information we are given indicates that an attempt has been made by a buyer or buyers to purchase Oxo cubes in the cheaper export market and resell them in the more expensive domestic market. Presumably the Oxo

72

INTRODUCTORY ECONOMICS COURSE COMPANION

cubes would have been sold in the domestic market at a price below that which Brooke Bond charges domestic consumers. (ii) In this case it would seem that consumer ignorance was an important barrier preventing seepage between markets. However, since Brooke Bond is taking action in the courts, there might also be some legal barrier preventing purchase and resale. In general the continuation of price discrimination requires the fulfilment of certain conditions, one of which is the existence of barriers which prevent seepage between markets. Consumer ignorance is one possible barrier, but it is not the only one and is by no means a necessary condition for the continuation of price discrimination. (ill) Brooke Bond clearly believe the ending of price discrimination will adversely affect profits. The fact that they are seeking action through the courts to maintain the practice indicates this, but might also indicate that some legal

regulation has been breached by the buyer's actions. (c) Brooke Bond has a monopoly over the supply of Oxo cubes and if there is greater competition from substitutes in export markets the elasticity of demand for Oxo cubes will differ between the domestic market and the export market (d) The most obvious reason Brooke Bond might use to justify its policy of price discrimination is that competition in the international market forces prices down to levels at which the company simply breaks even and realises a profit from its domestic operations. It might even argue that additional export sales make possible economies of scale and, in the absence of these, prices might even be higher in the domestic market. Depending on the levels of profit actually earned, an economist might interpret Brooke Bond's action as simply exploiting its monopoly position to increase its own profits.

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CHAPTER 13

IMPERFE CT COMPET ITION

Topic Summary

Equilibrium

Product Differentiation

Because of product differentiation, the firm in monopolistic competition will face a downward sloping demand curve for its product. If it increases price it will lose some, but not all, of its customers. Brand loyalty ensures it will retain some of its customers. Similarly by reducing price it will be able to increase sales. This implies that, as in pure monopoly, average revenue and marginal revenue will fall as sales increase. It also implies that the firm's marginal revenue curve will lie below its average revenue curve. Short run equilibrium under monopolistic competition is therefore identical to monopoly equilibrium and is illustrated in Figure 13.1. The firm maximises profit when it equates MC with MR. It will therefore produce OQ units and charge a price of OP per unit. However, if we subtract total cost (OTSQ) from total revenue

Competition is said to be imperfect when products are differentiated in some way. Products are differentiated either because they are real or imaginary differences between them. Real differences might be based on the use of different additives to produce a product or on slight differences in design. Imaginary differences are created through advertising which highlights some desirable, though indefinable quality a product purports to possess but which is not possessed by other products. In the case of real differences between products, advertising is used to reinforce differentiation.

Monopolistic Competition Assumptions Monopolistic competition exists when certain conditions are satisfied. In summary these are: • • • •

There are many sellers of a slightly differentiated product. There are many buyers each so small they have no individual ability to influence price. No single firm dominates the market, but each individual firm is large enough to influence market supply and therefore market price. In the long run firms are free to enter or leave the industry.

In such markets there will clearly be competition between firms since they produce only a slightly differentiated product. However it is important to note that there is also an element of monopoly: each firm has a monopoly over its own brand of the product.

Figure 13.1

competition

Short run equilibrium in monopolistic

Revenue and cost

AC

MR

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INTRODUCTORY ECONOMICS COURSE COMPANION

(OPRQ), it is clear that the firm is earning supernormal profit equal to PRST. Because there are no long run barriers to entry, the existence of supernormal profit will attract other firms into the industry. As more firms enter the industry, the demand for any individual firm's product will fall and its average revenue curve will therefore shift to the left. Demand for the firm's product will also become more elastic at any given price because consumers now have a wider range of products to choose from. The extent of the firm's monopoly power therefore decreases as the number of firms entering the industry increases. In fact firms will go on entering the industry until supernormal profits have been competed away and all firms earn only normal profit. This is illustrated in Figure 13.2.

Figure 13.2 Long run equilibrium in monopolistic

competition Revenue

and cost

AC

0

Q

Quantity

MR

Oligopoly Oligopoly is usually referred to as competition among the few. Of course the term 'few' cannot be interpreted unambiguously. We caml.ot say five is few but six is not! However the crucial point in oligopolistic markets is that the number of sellers is so small that the market is characterised by interdependence. In other words, each firm produces a significant part of total market supply and therefore any decision to adjust its price or its output will have repercussions on other firms in the industry. The model of oligopoly is usually generalised so that there are several producers of a slightly differentiated product. Such markets are easy to identify. Petrol, car tyres, motor vehicle production and so on are all examples of oligopolistic markets. However economists sometimes distinguish perfect oligopoly in which there is no product differentiation, from imperfect oligopoly, as described above. They also identify a special case of oligopoly, duopoly, in which there are only two producers. In this chapter we stick to the general case.

Price Stability in Oligopoly One feature of oligopolistic markets that attracts attention is their relative price stability. It is sometimes alleged that, once established, prices in oligopolistic markets will remain fixed for relatively long periods. Furthermore, when prices do change, all firms in the industry adjust prices either simultaneously or in quick succession. There are several possible reasons for this but the three most commonly suggested are the kinked demand curve, price leadership and collusion. We examine each in tum.

The Kinked Demand Curve In Figure 13.2 the firm is maximising profit when price is OP and output is OQ because at this price and output combination marginal cost is equal to marginal revenue. However, at the equilibrium price and output, the firm's average cost curve is just tangential to its average revenue curve and therefore, when the firm is in equilibrium, total revenue equals total cost, that is, the firm earns only normal profit. This is just sufficient to attract other firms into the industry. When normal profits are earned the mdustry is therefore in long run equilibrium.

In oligopolistic markets, the entire supply of a product consists of the output of a few large scale producers. Because of this, oligopolistic markets are characterised by a high degree of interdependence between producers. Any decision by one firm to adjust its output will affect all other firms because of its impact on market price. In forming price and output policies, therefore, each firm must consider how its rivals will react to any change. Oligopolistic behaviour has therefore been likened to a game of chess. Before making any move it is

IMPERFECT COMPETITION

necessary to consider how an opponent will react. This idea underpins the notion that oligopolists consider their demand curve to be kinked at the ruling market price. If we assume that there is no change in costs of production or demand for the product, if one firm raises price it will do so in isolation. Other firms have no incentive to increase price because they will gain consumers from the firm which does raise its price. For a price increase a firm's demand curve will therefore be relatively elastic. On the other hand, if one firm reduces price all other firms will be forced to match the price cut to avoid losing customers. For a price cut, therefore, the individual firm faces a relatively inelastic demand curve. This approach implies that each firm perceives its own demand curve to be kinked at the ruling market price' as shown in Figure 13.3. Figure 13.3 The kinked demand curoe showing that, as long as marginal cost fluctuates within the region of indeterminacy, the oligopolist will not adjust price or output

75

within the region of indeterminacy, XY, the oligopolist has no incentive to change price or output. The implications of this analysis can be further extended. If costs move out of the region of indeterminacy it is likely that oligopolists will adjust prices and possibly output. However, if costs are rising for one firm, they are likely to be rising for all firms and by equal amounts. After all, since firms produce a similar product they are likely to use similar techniques. All that will happen when costs increase is that all firms will increase prices simultaneously or at least in reasonably quick succession. Consequently a new price will be established and each oligopolist will perceive their demand curve to be kinked at the new market price. Despite its obvious appeal, it is important to note that the kinked demand curve is not a complete theory of oligopolistic behaviour. It simply explains why prices might be stable, but tells us nothing about how those prices are established in the first place. Other theories of oligopoly have more to say on this issue.

Price Leadership

Revenue

and cost

Another approach to oligopolistic behaviour is that a

price-leader exists. This firm leads the way in

o, y Quantity

MR

In Figure 13.3, DD is the appropriate demand curve for a price rise, and D1D1 is the appropriate demand curve for a price reduction. The kink at the ruling market price, P, gives the oligopolist a perceived demand curve of DAD1• Because the oligopolist is simultaneously at a common point on two demand curves, the associated marginal revenue curve will be discontinuous and will be indeterminate at the kink in the demand curve. Even if costs of production change, so long as marginal cost remains

initiating a price change and other firms simply follow suit. In the case of dominant firm price leadership the largest firm in the industry performs the leadership role. Other firms in the industry accept the power of the dominant producer to influence market supply and price, and simply follow any changes this firm initiates. A different approach is barometric price leadership, when firms in the industry accept that one firm interprets changes in supply and demand conditions more accurately than other firms and simply follow changes initiated by the barometric leader. Again this gives a possible explanation of price stability in ologopolistic markets, but it also provides a more complete theory of oligopoly. Prices are stable because they are established by the leader and other firms simply react passively to any changes the leader initiates. This is a more complete theory of oligopoly because we can identify the way in which prices might be set in oligopolistic markets. The leader is able to act in the same way a monopolist would act because there is no fear of competition. The leader therefore simply adjusts price and output so as to maximise profit and other firms charge the same price as the leader and adjust their output so as to preserve this price.

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INTRODUCTORY ECONOMICS COURSE COMPANION

Collusion A third approach stresses that, because there are only a few producers in oligopolistic markets it is relatively easy for firms to collude over price and output decisions. The highest degree of collusion exists when firms form a cartel. In this case firms agree on a common price and accept output quotas to ensure that the agreed price is maintained. Here again we have a possible explanation of price stability and a more complete theory of oligopolistic behaviour than is offered by the kinked demand curve. Prices are stable because they are fixed by agreement. In the case of a cartel the combined marginal cost of all producers is equated with the overall marginal revenue curve to give the profit maximising price and output for the cartel as a whole, and then the output is divided into quotas which are allocated to members according to some agreed formula. Most cartels are illegal in the UK because the aim is clearly to establish higher prices than would exist in competitive conditions. Economists also argue that, since cartels effectively function as a monopoly, there is an implied efficiency loss which occurs whenever price is not equated with marginal cost (see p. 57). However, unlike the case of pure monopoly, there is no possibility of an offsetting gain in productive efficiency through the realisation of economies of scale.

of price leadership, is there an agreement, tacit or otherwise, to follow all courses of action initiated by the leader, nor is there any exchange of information between managers about price and output changes or other marketing strategies. There is certainly no agreement to accept a quota which fixes each firm's output. All of these are characteristic features of a

cartel.

Questions and Answers Questions 1 Which of the following distinguishes perfect

competition from monopolistic competition? A B

A large number of firms in the industry No barriers against firms entering or leaving the industry C Many buyers of the product or service D Small firms, in relation to the size of the industry E A homogeneous product or service ULEAC, June 1991 2 In oligopolistic markets the existence of a kinked demand curve implies that 1 2

Common Mistakes to Avoid It will be recalled from p. 75 that in the long run, under conditions of monopolistic competition, the firm earns only normal profit. However it must not be inferred from this that monopolistic competition is as efficient a market form as perfect competition. Remember, in monopolistic competition each firm has a monopoly over the supply of its own brand. Even in the long run each firm therefore faces a downward sloping demand curve for its own product and in maximising profit it will never equate price with marginal cost as occurs in perfect competition in the long run. As in pure monopoly there is a welfare loss associated with monopolistic competition. It is also important not to confuse price leadership with the existence of a cartel where there is a formal agreement among firms to charge a common price for their product. In the case of price leadership, firms choose to follow the leader and are perfectly free to pursue a different policy at any time. In neither case

3 A B C D E

Firms avoid competition between each other. Prices do not change unless costs of production change. Oligopolists are aware of a high degree of interdependence between them 1, 2 and 3 1 and 2 only 2 and 3 only 1 only 3 only

1 Both perfect competition and monopolistic competition assume the industry consists of a large number of small firms. This implies an absence of significant economies of scale so that no firm grows to a size where it can dominate the market. Option A is incorrect. Both market forms also assume there are no barriers to entry or exit. It is this assumption which ensures that in both markets firms only earn normal profit in the long run. Option B is incorrect.

IMPERFECT COMPETITION In both markets there are many buyers of the product or service, which implies that no single buyer can influence price. Option C is incorrect. Similarly, as explained above, firms remain so small they are unable by their individual actions to exert any influence on market price. Because of this we can assume away any possibility of retaliation by other firms if one firm changes its price. Other firms will not retaliate because they will be unaffected! Option D is incorrect. In perfect competition a homogeneous product or service is supplied, whereas in monopolistic competition each firm has a monopoly over its own brand of the product. This is what distinguishes perfect competition from monopolistic competition. Option E is correct. The key is E.

2 In oligopolistic markets the existence of a kinked demand curve implies an absence of price competition between two rival firms but it most certainly does not imply a total absence of competition. Indeed

77

oligopolistic markets are often characterised by a high degree of non-price competition between firms. Option 1 is correct. The theory of the kinked demand curve does not imply that the only influence on price is costs of production. It is quite possible that a change in demand for the product, independently of any change in costs of production, will result in a change in oligopolistic prices. Option 2 is correct. If firms perceive their demand curve to be kinked at the ruling market price, this implies the existence of a high degree of interdependence between them. They believe that if they raise the price of the product they will do so in isolation and will therefore lose sales to rival firms. On the other hand, they believe that if they cut the price of their product other firms will be obliged to match the price cut to avoid a loss of sales. It is such interdependence which gives rise to the possibility of a kinked demand curve and therefore option 3 is correct. The key is E.

REVIEW QUESTIONS AND ANSWERS

Questions Question 1 is based on the following extract:

Oil price tumbles - 14 dollars a barrel By GEORGE SlVELL, City Editor

NORTH SEA oil prices fell below 14 dollars a barrel yesterday for the first time since the 1986 oil crisis. At one stage yesterday a barrel of North Sea crude could have been had for as tittle as 13.85 dollars, a fall of a dollar on the day. Concern in the City over the oil price has mounted in the past few days as it has become clear that the relatively mild European winter and continued strong production by the Opec cartel have left oil stocks at the highest level for five years. Opec production is now estimated at just below 17 million barrels a day for January and just above for February.

These levels are still within the agreement which was rolled over at the December Opec meeting but the pressure still remains on prices because certain states are coming under pressure to offer discounts to their main customers. Such has been the level of discounting that prices on the oil markets are now four dollars adrift of the official Opec price of 18 dollars a barrel. Prices have held to an average 18 dollars over the past year but dipped to just below 16 dollars in mid-December on dismay that Opec had failed to agree firmer production quotas or pricing controls.

Opec is not due to meet again until June and in the meantime Saudi Arabia, which took up any production slack, has complicated matters by abandoning its role as a swing producer. Before the oil price crisis of 1986 the Saudis would always cut output when production accelerated and prices weakened. But Saudi Arabia actually increased production from an estimated four million barrels in January to 4.3 million barrels in February. "March is going to be a very severe test for the oil market," said one analyst last night.

Source: WNtem Mllft, 3 March 1988.

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INTRODUCTORY ECONOMICS COURSE COMPANION

(a) On what grounds would the extract lead to the conclusion that oil is not bought and sold in a perfect market? (b) Saudi Arabia is described in the extract as a 'swing producer'. Explain this term, and describe how the abandoning of this role destabilises oil prices. (c) Describe the effects on the price and output of oil of the events of August 1990 when Iraq invaded Kuwait.

2 Since excess capacity is a prediction of the theory of monopolistic competition, does it necessarily follow that society would benefit from a reduction in the number of firms in such a market?

3 Under monopolistic competition price taking does not occur. Explain why it is nevertheless likely that firms will have only very limited control over the market clearing price. 4 It can be argued that the banking industry, which was once very oligopolistic and collusive in the UK, is now much more competitive. What factors have influenced this trend?

5 Is collusion between firms necessarily undesirable? 6 Describe and account for differences in expenditure on advertising between industries.

Answers 1 (a) There is clear evidence in the extract we are given that the oil market is not perfect. We are told in the second paragraph that oil stocks are at least influenced by a cartel. In perfect competition it is assumed that there are many suppliers of a product who act independently. We are further told in the fourth paragraph that certain OPEC members are under pressure from buyers to offer a discount on oil sales. Again under perfect competition each buyer is so small that they are unable to influence the price of the product. Later we are told that Saudi Arabia is a 'swing producer', that is, a supplier which heavily influences the market supply. This is yet another breach of the assumptions of perfect competition. (b) A swing producer is a supplier which adjusts its output in response to changes in market demand for a product so as to preserve an agreed market price. By abandoning this role

Saudi Arabia is free to adjust its output of oil so as to achieve its own aims. We are told in the extract that Saudi Arabia increased its output at a time when there was already a surplus of oil on the market and this explains why the price of oil tumbled to 14 dollars a barrel. (c) Kuwait was a major exporter of oil before the Gulf War. Immediately after Iraq invaded Kuwait, exports from Iraq and Kuwait were cut off and the world supply of oil fell. The price of oil inevitably increased but not by as much as was feared. There are several reasons for this. For example, Saudi Arabia and several other OPEC members increased their output, President Bush released the strategic oil reserves onto the American market and the Gulf War did not, as was feared at one stage, spread throughout the Arab world.

2 Firms in monopolistic competition will always cease production at a point where average cost is still falling and will therefore always operate with excess capacity. However fewer firms will not necessarily result in firms increasing their output and moving to the point of minimum average cost. A reduction in the number of firms implies an increase in monopoly power for those firms remaining in the industry. Because of this, the reduction in competition might actually increase inefficiency! 3 Firms in monopolistically competitive markets have only limited, if any, ability to influence market price because individually they produce such a small part of total market supply. 4 Deregulation of the banking industry has outlawed collusion in banking and increased the number of firms offering banking services. There has also been an increase in the number of foreign banks establishing premises in the UK. Another factor has been the reduction in the cost of banking activities, in particular the cost of clearing cheques, made possible by technological advances. 5 Collusion, by ensuring price stability, might have beneficial effects on society. It ensures long run supply of the product and might guarantee the existence of smaller producers who might otherwise be forced out of the market.

6 Differences in advertising expenditures largely reflect different degrees of competition m different markets.

79

CHAPTER 14

LABOUR

p. 220, this is one of the sources of economic growth. As a factor of production, labour refers to the input of human effort. The value of this input is quite substantial, and even in a developed economy such as the UK, labour costs account for well over 50 per cent of the total value of output produced.

Division of Labour Division of labour refers to specialisation of labour. This might imply specialisation in a particular occupation, but increasingly labour now specialises in the performance of a particular task or small group of tasks within an occupation. Division of labour is common in all sectors of industry: primary, secondary and tertiary alike.

The Advantages of Specialisation Specialisation is so common because it facilitates an increase in productivity. There are several reasons for this but in general the main reason is that specialisation makes possible the use of more specialised capital equipment. Without specialisation of labour, investment in specialised units of capital would be uneconomic because they would not be in use continuously throughout the working day. Without continuous use, the average cost of such capital equipment would be prohibitive. It is also true that when workers specialise less time is wasted, since they are not moving from job to job. In addition it is easier to train workers since they only perform a narrow range of tasks and by their repeating the same tasks throughout the working day the speed at which they perform these tasks is likely to increase. For whatever reasons productivity increases, the fact that it does confers a major benefit on society. Strictly an increase in productivity implies an increase in output from a given amount of input. When productivity increases, therefore, society is using its resources more efficiently and, as we shall see on

The Disadvantages of Specialisation Despite the advantage of raising productivity, increased division of labour also has certain disadvantages. For the majority of workers there is no doubt that increased productivity implies increased boredom. On the other hand, higher productivity has led to higher real wages. For individual firms (and the economy as a whole) a more serious problem is that if a small group of key workers are absent from work, for example because of illness or strike action, production can be seriously disrupted and in some cases can grind to a halt.

Mobility of Labour There are two broad types of mobility: geographical and occupational. Geographical mobility refers to the movement of a factor of production from one location to another, whereas occupational mobility refers to a factor of production changing its occupation. Both types of mobility are important if an economy is to operate efficiently. Consumer demand and technology are constantly changing, and without a mobile labour force it is impossible to respond fully to these changes.

Population Population growth is important to economists because it affects the future supply of labour and the future demands on a nation's (or the world's) resources.

The Labour Supply Many factors determine the potential labour supply to an economy. The main factors can be summarised as follows:

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INTRODUCTORY ECONOMICS COURSE COMPANION

Size of Population Other things being equal, the larger a nation's population, the larger its potential supply of labour. Population size depends on the birth rate and the death rate plus net migration, that is, emigration minus immigration. Population Age Structure An economy with a large proportion of people at or above retirement age and/or a large proportion under school leaving age will tend to have a smaller labour supply, though as children mature they will add to the labour supply; As well as the age structure of the population, the minimum school leaving age and the age of retirement have important effects on the supply of labour. Population Sex Structure In all countries men are more likely to seek paid employment than women. There are many possible reasons for this. In Moslem countries religious principles prevent most women from entering the labour market. In other countries women often withdraw from the labour market to raise a family. For whatever reason, if the sex structure of a nation's population is more heavily biased in favour of women than men, then, if all other things are equal, the labour supply will be smaller than if men outnumber women. Standard Working Week The labour supply is usually measured in number of hours per week. The number of hours worked per day, length of the working week and the number of public holidays per year will all therefore influence the supply of labour.

UK Population Trends The UK population exhibits certain characteristics that are common to most developed countries: a declining birth rate (number of live births per thousand of population) and a declining death rate (number of deaths per thousand of population). The decline in the birth rate is relatively slight from year to year, whereas the decline in the death rate is more marked. If the birth rate continues to decline it will ultimately lead to a falling population, but at present the decline in the birth rate is so slight that the focus of attention is the increasing average age of the population. In general an ageing population might have several effects: •

An ageing population implies an increase in the dependency ratio, that is, the ratio of the

•

•

•

working population to total population. A rising dependency ratio implies that the working population will have to support a larger number of non-working people. In a developed economy like the UK this implies that the standard of living (output per head - see p. 105) will rise less quickly than it would have done if the population had remained static. An ageing population will cause changes in the pattern of demand for different goods and services. For example, more demands will be made on the health services and on the social services. There will be an increased demand for sheltered accommodation, and so on. It is usually very difficult for younger people to save out of current income. Personal sector saving tends to be undertaken by other groups and it seems reasonable to suggest that an ageing population will be associated with an increase in personal sector saving. Additional saving will make possible a higher level of investment and might increase productivity. An ageing population is a less mobile population both geographically and occupationally. However the effect of this is difficult to ascertain. In the UK the main reason for the increase in the average age of the population is that there has been an increase in life expectancy, that is, those of retirement age and over now live longer. Since those in this group are not part of the labour force, a reduction in their mobility has no relevance!

The Optimum Population An optimum population is said to exist when

average product is at a maximum. If the population

is less than the optimum, a nation is said to be underpopulated and if it is greater than the optimum it is said to be overpopulated. These concepts are illustrated in Figure 14.1. The optimum size of population in this case is ON. Many factors determine the optimum population and it is not a static concept. An increase in the capital stock, or the skills the labour force possess, will increase the optimum population. Discoveries of raw materials such as oil in the North Sea will also affect what is considered an optimum population. However, in modem economies the most important factor is undoubtedly technological progress. In particular, greater technological progress, by increasing the productivity of labour, will increase the optimum population.

81

LABOUR

Figure 14.1 The optimum population (ON)

The Rise of Part-time Jobs Many women prefer to combine employment with running a home and organising a family. The growth in the number of part-time jobs in the UK has increased the opportunity for this and women have responded by taking up most of the opportunities for part-time employment. It is estimated that, between 1951 and 1990, part-time employment as a percentage of total employment increased from 4 per cent to 27 per cent and that, in 1990, 88 per cent of all part-time workers were women.

Average

product

0

N

Rising Real Income Size of population

Increasing Participation of Women in the Labour Force Women now constitute over one third of the total labour force and the number is rising. At the start of the 1970s only 43 per cent of females in the working age groups participated in the labour market. By the 1990s this figure had risen to over 60 per cent. There are many reasons for the increasing participation of women m the UK labour market, including the following:

Changes in Social Prejudice Increasingly the prejudice against women participating fully in the labour market has diminished. In consequence women are more active seekers of employment than they might have been years ago. To some extent this reflects the labour shortages which characterised the 1950s and 1960s. Shortages of labour increasingly drew more women into paid employment and this established the pattern for the future.

Changes in the Structure of Industry The decline of the industrial base in recent years, coupled with the expansion of the service sector, has increased the number of opportunities for women to participate in the labour market.

In post-war years there has been a considerable rise in real income and this has increased the sacrifice involved in not obtaining employment. It seems reasonable to suggest that, as the opportunity cost of non-participation in the labour market has increased, so the number of job seekers has increased. Because of the relatively low participation of women, the increase in the number of females seeking employment has been more significant than the increase in the number of males seeking employment.

Tax Advantages In 1988, the tax laws were changed to allow women to be taxed independently of their husbands. For many women this increased the attractiveness of paid employment because it reduced the risk of joint income pushing the family into a higher tax bracket. The effect was therefore to increase disposable income from employment for at least some married women.

Common Mistakes to Avoid A very common mistake is to confuse working population with the numbers in the working age groups. They are not the same! The working population consists of those in paid employment (full-time or part-time), the self-employed, those in the armed forces and those registered as unemployed. The working age groups consist of all females between the ages· of 16 and 60, and all males between the ages of 16 and 65. There will be clear differences between these totals because of those in full-time education, the unemployed, those who work

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INTRODUCTORY ECONOMICS COURSE COMPANION

full-time as a homemaker, pensioners, those who do full-time voluntary work, and so on. It is also important to distinguish between the growth rate of the population and the natural rate of increase of the population. The natural increase in population is measured by the difference between the live birth rate and the death rate. Crude birth rate

=

Crude death rate

=

Natural rate of increase

=

(a) Given that the data suggest that the proportion of the population who are of working age in the Republic of Ireland is going to increase over the period 1991-2001, explain why an increase in employment levels may not result in a reduction in unemployment rates. (b) Throughout the period shown, evidence (not given here) suggests that birth rates in the Republic of Ireland will exceed death rates. How then can the statistics point to a fall in population size? (c) The projected age distribution of the UK . population shown in Table 1 forecasts a decline in the proportion of the population who are of pensionable age and over and an increase in the proportion under school leaving age. How then can it be that the median age of the population is projected to increase by 1.7 years in a period of only 10 years? (d) It has been suggested that, whilst in 1991 the population of Northern Ireland lay somewhere between that of the United Kingdom and the Republic of Ireland in its demographic characteristics, by the year 2001 it will resemble the United Kingdom population less than the Republic of Ireland population does. To what extent do the data support this view? (e) The results of the 1991 Censuses of Population in both the United Kingdom and the

number of births per annum per thousand of the population. number of deaths per annum per thousand of the population. birth rate - death rate.

If we allow for net migration (emigration minus immigration), the growth rate of the population can be set out as: Growth rate

=

birth rate - death rate + net migration.

Questions and Answers Questions

--------------------------~

1 The data in this question are concerned with the projections made in 1986 of the populations of Northern Ireland (NI), the United Kingdom (UK) and the Republic of Ireland (RI) for the three years 1991, 1996 and 2001.

Table 14.1 Projected population sizes and .:.,_ percentage age distributions 1991

Age group Under school leaving age Working age Pensionable age and over Population (millions) Median age (years)

1996

2001

NI

UK

RI

NI

UK

RI

NI

UK

RI

26.5 59.1

20.4 61.3

'2:1.0 59.9

26.4 59.2

21.3 60.5

24.6 62.2

25.7 60.0

21.6 60.4

22.8 63.8

14.4

18.3

13.1

14.4

18.2

13.2

14.3

18.0

13.4

1.61

57.5

3.54

1.65

58.3

3.50

1.68

59.0

3.49

30.3

35.8

29.3

31.3

36.4

31.5

32.4

37.5

33.4

Notes: (i) In 1986, the school leaving age in the Republic of Ireland was 15 years, one year below that in the United Kingdom. Pensionable ages were the same (65 years for males and 60 years for females). It is assumed in these projections that there will be no changes prior to 2001. (ii) The median age is that which divides the population in half, in that 50 per cent are younger than it and 50 per cent older.

LABOUR

Republic of Ireland are almost certainly going to lead to the projections shown in Table 1 being revised. As an economist, what factors do you think should be taken into account when determining the frequency of censuses? NISEAC, June 1991 2 Which of the following is (are) usually suggested as an advantage of the division of labour? It makes greater use of machinery possible. It encourages the preservation of craftsmanship. 3 It increases the size of the market. A 1, 2 and 3 B 1 and 2 only C 2 and 3 only D 1 only E 3 only 1 2

Answers 1 (a) The rate of unemployment is measured as the percentage of the working population who are registered as unemployed. The working population consists of those in employment, including the selfemployed, those in the armed forces and those registered as unemployed. The data we are given show that for the Republic of Ireland the percentage of the population in the working age group is expected to rise from 59.9 per cent in 1991 to 63.8 per cent in 2001. This represents an increase of about 136ll0 people in the working age group. Unless employment increases by at least this number between 1991 and 2001, the rate of unemployment in Northern Ireland will increase. (b) Population growth is affected by only three factors: the live birth rate, the death rate and net migration, that is, emigration minus immigration. In the Republic of Ireland between 1991 and 2001, the birth rate is expected to exceed the death rate and therefore the natural rate of increase in population is expected to be positive. In these circumstances the growth rate of population can only be negative if emigration exceeds immigration by an amount greater than the absolute difference between the number of live births and the number of deaths per year. (c) The data we are given show that for the UK the proportion of the population of pensionable age and over is forecast to fall, while the proportion under school leaving age is forecast to rise. If all other things remained equal, these changes would tend to reduce the median of the UK population as the absolute numbers under school leaving age

83

increased relative to the absolute number of retirement age and over. The forecast increase in the median age of the UK population therefore implies that there is an expected increase in life expectancy. In other words, although the proportion of the UK population of retirement age and over is expected to fall, the average age of those in this group is expected to rise. (d) A full comparison of demographic characteristics is impossible from the information we are given. It is not easy to see from the data why the population of Northern Ireland might lie somewhere between the population of the UK and the Republic of Ireland. The proportion of the population under school leaving age in Northern Ireland is less than the proportion in this age group in both the UK and the Republic of Ireland. The same is true of the proportion of the population of working age and of pensionable age and over. Only the median age of Northern Ireland's population compared to the median age of the population of the other two countries lends support to the view that in 1991 the population of Northern Ireland lies somewhere between that of the UK and the Republic of Ireland in terms of its demographic characteristics. In 1991, the demographic characteristics of Northem Ireland closely resembled those of the Republic of Ireland. Although the situation is expected to change by 2001, there is little evidence that the demographic characteristics of Northern Ireland will resemble the characteristics of the UK less closely than the Republic of Ireland does. The proportion of the population in the under school leaving age group in Northern Ireland is expected to exceed the proportion in this group for the UK by 4.1 percentage points. The position of the Republic of Ireland for the same group is closer to the UK and only exceeds the UK by 1.2 percentage points. However in both other groupings the population of Northern Ireland more closely resembles the population of the UK than the Republic of Ireland does. Indeed the proportion of the population in the working age groups for Northern Ireland is expected to be only 0.4 percentage points behind the UK, whereas the proportion in this group for the Republic of Ireland is expected to exceed the UK by 3.4 percentage points! If we consider those of pensionable age and over, the population of Northern Ireland is again expected to be closer to the UK than the Republic of Ireland is expected to be. Admittedly there is expected to be only 0.9 percentage points between the proportion of the population in this group in Northern Ireland and the proportion of the population in this group in the Republic of Ireland, but the difference between

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INTRODUCTORY ECONOMICS COURSE COMPANION

Northern Ireland and the UK is still smaller than the difference between the Republic of Ireland and the UK. Again only the expected median age lends support to the assertion that the demographic characteristics of the population of Northern Ireland in 2001 will resemble the UK population less than the population of the Republic of Ireland does. (e) In determining the frequency with which a census should be carried out there are two broad considerations. On the one hand, the more frequently a census is carried out, the more accurate the information it will contain. This is important in forecasting future demand for most goods and services, especially those provided through the public sector where investment is financed from tax revenues. On the other hand, the more frequently a census is carried out, the greater the cost involved in gathering information. The opportunity cost to society must therefore be considered. This boils down to an optimisation problem and the solution would be where the gains to society from more accurate information are equal to the cost of gathering this

information. If the cost of gathering information is less than the benefits of possessing such information, the allocation of resources could be improved by increasing the frequency with which a census is carried out and vice versa.

2 When production is broken down into a small number of repetitive tasks there are far greater opportunities for the substitution of capital for labour. Option 1 is therefore correct. Option 2 is incorrect because greater and greater specialisation implies a decline in craftsmanship.Workers simply perform a series of repetitive tasks. Specialisation makes greater levels of output pssible but this does not increase the size of the market. On the contrary, the size of the market limits the scope for specialisation. Unless large scale sales are possible large scale production is uneconomic. Option 3 is therefore incorrect. The key is D.

REVIEW QUESTIONS AND ANSWERS

Questions 1 How does the degree of specialisation affect productivity?

2 In what ways, if any, might the mobility of labour be affected by (i) the introduction of a National Curriculum in UK schools, (ii) an increased tendency for people to buy their own homes, with a corresponding reduction in the size of the privately rented housing sector? 3 The more specialised a factor of production the higher its productivity, but the lower its mobility. Why is this?

4 How would you assess whether Britain was overpopulated or underpopulated?

5 Why might (a) companies producing goods and services, and (b) local and central government, be interested in whether future trends will show an expanding, declining, or ageing population? 6 For what reasons might some of the less prosperous regions of the UK find that they have even fewer 15-19 year olds than other

areas during the 1990s? What problems might they face as a result?

7 Analyse the arguments for and against some-

one who reaches the age of 18 in the year 2000 leaving school for a mechanical apprenticeship rather than going to university to read for a degree.

Answers 1 The greater the degree of specialisation, the greater the productivity of any factor production. In the case of labour there are many reasons for this. For example, specialisation of labour makes greater use of machinery possible and reduces the time required for training. 2 (i) The National Curriculum aims to ensure a more broadly based education in schools and to raise educational standards. The more broadly based curriculum might increase the number of students studying sciences and through this the number of entrants into science based courses such as engineering. The National Curriculum will therefore make possible a wider career choice

86

CHAPTER 15

ENTERPRISE

Topic Summary Of all factors of production the entrepreneur is the

most difficult to define. It is usually argued that the entrepreneur is the individual who bears the uninsurable risks of production. In this sense the entrepreneur is regarded as a true capitalist, that is, one who risks his or her funds in the pursuit of profit from some productive activity. However, the entrepreneur is also regarded as an organiser and a decision-taker. In this sense the entrepreneur's role is to decide what the factors of production will produce, how they will be combined, how the product will be marketed and so on. The entrepreneur might also be an innovator who recognises an opportunity for profit from the inventions of others. Beyond this little can be said by way of obtaining a precise definition of the entrepreneur. Economic theory has so far largely ignored the way in which the entrepreneur initiates, carries on and brings to a successful conclusion some productive activity. Neither is there any agreement on whether the entrepreneur is an individual or might constitute a group of people such as a family. It is sometimes argued that the functions of the entrepreneur are split as in public companies, where the management and ownership responsibilities, the traditional functions of the entrepreneur, are carried out by salaried personnel and shareholders respectively.

Characteristics of the Entref!.reneur Despite these problems with identifying a functional definition of the entrepreneur, it is often argued that the entrepreneur will possess certain characteristics that will set him or her apart from other factors of production. These are easily summarised.

Greater Occupational Mobility Whatever it is an entrepreneur does, there seems no reason why the skills and abilities should be specific

to one firm or one industry. The ability to organise, to recognise and exploit opportunities for profit, the ability to take decisions and bear risks, all of which are associated with the entrepreneur, are not industry-specific. Because of this it is likely that entrepreneurial talent, displayed by an individual in one organisation or industry, will draw that individual into other industries where entrepreneurial talent can again be displayed. Richard Branson is often regarded as one who possesses entrepreneurial talent and he has certainly proved that his abilities are equally well suited to running a chain of record shops or running an international airline.

Indeterminate Reward There is a view that the risk an entrepreneur takes stems from the fact that the entrepreneur supplies risk capital, that is, an entrepreneur invests his or her own funds in an organisation. Since he is a risktaker, an entrepreneur's income is likely to be directly derived from profits of the organisation. Unlike other factor incomes, profit cannot be fixed in advance of production: it is the residual amount left over after all other factor incomes have been paid.

More Variable Income Moreover, because an entrepreneur sometimes risks personal funds in a business venture, he or she has a vested interest in the success of that business venture. The more successful the business, the greater the return to the entrepreneur. Failure implies that an entrepreneur might lose the value of the funds invested, whereas there is no fixed limit on the return from a successful business. In any event, whether a business succeeds or fails, for most businesses the level of profit earned fluctuates with the level of economic activity. During periods of buoyant economic activity, when the economy is booming, profits will tend to rise, whereas, during a reces-

ENTERPRISE

sion, when economic activity is depressed, profits will tend to fall. In consequence it can be argued that no other factor income will fluctuate as widely as the return to the entrepreneur.

The Divorce of Ownershi and Control In most Western economies large business organisations are owned by shareholders who literally own a share of an organisation. These organisations are known as joint stock companies. The shares in public companies can be transferred from one shareholder to another almost without restriction, whereas in private companies there are usually restrictions to prevent the transfer of shares to parties other than those approved by existing shareholders. The reason for this is that in public companies the shareholders appoint salaried managers to run the company on their behalf, whereas in private companies the shareholders wish to retain control themselves. In public companies the divorce of ownership from control raises the issue of what aims the company will pursue. Obviously the owners will require a rate of return on their investments in the company which they consider satisfactory and this implies that the company must aim at a minimum profit. They have some power to ensure this because they elect a board of directors annually and it is this group that decides company policy. However achieving a minimum level of profit allows ample scope for the board of directors to pursue other aims. Traditionally economic theory has assumed that firms aim to maximise profit. Companies might well pursue this aim. However profit maximisation is a risky strategy since it means altering price and output levels as market conditions change. This might antagonise customers who find that frequent

87

price changes make it difficult for them to plan their own purchase requirements. It is also a risky strategy because, if successful, it might encourage other firms to enter the industry if profits are high enough and in these circumstances increased competition might well depress profits for existing producers. If managers were also the owners of companies these risks might be perceived differently. After all, entrepreneurs are risk-takers and the threat of competition might well encourage a policy of profit maximisation. However, because salaried managers are not usually also company owners, they might consider an alternative policy. One alternative frequently suggested is a policy of sales maximisation. This might be an attractive policy, for various reasons. As sales increase, market share is likely to increase and this will give a company more security against the emergence of competitors. The company's long term survival prospects, and therefore the job security of its managers, might therefore be enhanced by a policy of sales maximisation. There are other factors to consider. Since it is impossible to know for certain what level of profit would be earned under a policy of profit maximisation, it could be argued that shareholders have no way of knowing whether managers are maximising profit or not. For them, the important consideration is whether they find the return on their investment satisfactory. They are more likely to do so when market share is increasing rather than when it is static, or even shrinking. However, perhaps the most important consideration of all is that the salaries of managers are most frequently thought to be related to market share rather than profit. The larger the organisation, the more complex it is to manage. If salary is indeed linked with company size, managers might have a vested interest in maximising sales and growth rather than profits.

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INTRODUCTORY ECONOMICS COURSE COMPANION

REVIEW QUESTIONS AND ANSWERS 4 Consider the article in Figure 15.1, which appeared in the Guardian:

Questions 1 Explain how a public limited company forms part of the private sector of the industry. 2 To what extent could a registered charity such as the RSPCA be regarded as an enterprise? Who carries out the functions of the entrepreneur within such an organisation?

(a) To what extent does this article reinforce the view that there is a divorce between ownership and control? (b) Many school pupils now take part in 'enterprise' activities. Is it possible to learn how to be enterprising?

3 If a company devotes resources to sponsoring

5 Is entrepreneurship possible within large

a symphony concert, is this a sign that the firm is not maximising profits? In what way could it be argued that such sponsorship has a direct link with profitability?

Figure 15.1

organisations? Suppose you were employed by a multinational car manufacturer. What opportunities might there be for you to display the characteristics of entrepreneurship?

What motivates tycoons

The British Psychological Society hears what motivates tycoons, and the risks in moving staff

Entrepreneurs' spur to success Cllrls 11111111 j llltllcal Cormpo•dtlt

IT

ycoons who founded multi-million pound empires are more likely to be poorly educated, come from deprived backgrounds and have had mothers with strong personalities, a study of successful people has found . The personality of entrepreneurs is signifi1 cantly different from that of seruor managers and company chairmen who worked their way up the corporate ladder. A unique study of what motivates elite businessmen and the forces that shaped their drive has been carried out by a mature PhD student, Reg Jennings, which involved detailed interviews with some of the richest and most powerful business people in this country and the United States. The four-year study consisted of an analysis

I

of self-reported characteristics of 19 entrepreneurs and 22 managers, two of whom were women. The entrepreneurs included Lord Young, the former Trade and Industry secretary, George Davies of Next, businessman Owen Oyston, publisher Eddie Shah, Gerald Ronson of the Heron group financier Peter de Savary, and Jeffrey Archer. The managers included Anthony Pilkington of Pilkington glass, Lord McAlpine, Julian Smith of W H Smith , Sir Adrian Cadbury of Cadbury Schweppes , Sam Whitbread of the brewing firm, and Denis Thatcher. Mr Jennings, of Lancaster University, told the annual meeting of the British Psychological Society in Bournemouth at the weekend that the hardest part was getting access to the people . Once he had done so, they were happy to talk, although reluctant to fill

in personality questionnaires. An analysis of their characteristics found the entrepreneurs had higher reserves of energy, were more creative thinkers, more risk-seeking, but becoming bored with routine. They were more likely to attribute their success to luck. They also strongly believed their early years of poverty had shaped their ambition, and, in particular, that their mothers had been a strong influence. Mr Jennings said the entrepreneurs "gave not a damn for education," usually having left school at 15. The managers had usually been to the best schools. The entrepreneurs sought excitement and saw adversity as a challenge. Lord Young said: "I spent a very miserable year in 1973 when I thought I was rich and didn't know what to do. Very luckily for me the

1974 bank crash wiped me out and I woke up one morrung full of the joys of spring because I knew what I had to do." One tycoon said being Jewish in a poor area and being beaten up nearly every day of his school life had acted as the spur to prove himself. Owen Oyston, Peter de Savary and Jeffrey Archer all said their mothers had influenced them strongly. Mr Oyston commented: 'I was ill for years at school. My mother was the driving force . She created in me an uneasiness about not working and the pressure for me to really prove to the world what I had in me." By contrast , Denis Thatcher said: "As a businessman I am still, and always have been, the professional director . The decision-maker, yes, but not with the flair of the real entrepreneur."

Source: Guardian, 15.4.91.

I

ENTERPRISE

Answers 1 The public sector consists of those organisations which are state owned and which are controlled by central or local government either directly, as with the armed forces, or through their agent, as with the nationalised industries. Public companies do not fall into this category because in general they are owned by private individuals. The exceptions are registered charities and trusts.

2 An enterprise is usually defined as an organisation and in particular a business organisation. The RSPCA is a registered charity rather than a business organisation and its ultimate aims differ radically from those of a business organisation. It has no product to sell and therefore does not aim to maximise profit or market share. Nevertheless it does aim to maximise donations and holds fund raising events to achieve this. It also actively advertises its work to encourage donations from the public. Like most organisations it has limited availability of funds and no doubt aims to place the funds at its disposal where they will achieve maximum benefit in preventing cruelty to animals. In this sense the RSPCA is clearly an enterprise. 3 Sponsorship of events such as a symphony concert might well be done for altruistic motives. If this is the case it might well be true that a firm is not maximising profits. However, before we can be sure, we need to know the amount of sponsorship money involved, the total sponsorship budget, how much exposure the firm received as a result of its sponsorship and so on. In many cases there is no doubt that sponsorship is used as a means of advertising a firm and its products. In this sense there is a direct link between sponsorship and profitability. 4 (a) The article we are given provides some information on the personal backgrounds of managers and entrepreneurs but it provides little evidence of a divorce between management as a decision-taking function and risk-seeking as an entrepreneurial function. Those individuals referred to as 'managers' in the passage are decision-takers on behalf of their employer. The traditional view of the entrepreneur is one who recognises profitable opportunities and is willing to risk personal funds backing his or her view. The distinction is clear in Dennis Thatcher's statement when he admits to being a decisiontaker, 'but not with the flair of the real entrepreneur'.

(b) It is probably true that schools and other educational establishments can teach individuals to be more enterprising, but it is doubtful whether it is possible to teach an individual to be enterprising. The passage we are given indicates that entrepreneurs are 'risk-seekers' who become 'bored by routine'. They apparently have 'higher reservers of energy' than others. These are personality traits that cannot be taught in schools or learned from a book. Similarly they 'strongly believed their early years of poverty had shaped their ambition, and, in particular, that their mothers had been a strong influence'. Again these influences cannot be taught. Despite this it is possible to teach individuals some aspects of the 'enterprise culture'. There are skills involved in time management and in seeking out profitable opportunities. It is also possible to teach the use of decision-making techniques such as discounted cash flow techniques (see pp. 123-4). Similarly it is possible to teach other techniques used in business, such as profit and loss accounting and advertising as well as the various sources of finance available to a business. Furthermore, in many schools, enterprise activities frequently involve running a 'business' and the experience this provides will no doubt aid individuals to be 'enterprising'.

5 Many large organisations are owned or controlled by individuals classed as entrepreneurs. Richard Branson's Virgin Atlantic is an often quoted example. However in large organisations there is generally less scope for entrepreneurship because of the divorce between ownership and control. The largest organisations are the joint stock companies, and it is the shareholders who bear the risks of business failure while salaried managers exercise control. Entrepreneurshi p is clearly an essential ingredient of any business organisation but it is difficult for one person to finance the largest organisations and so different groups carry out the different functions of the entrepreneur. Whether there is scope to exercise an entrepreneurial role in a large multinational organisation partly depends on the qualities an individual possesses and on the position that person occupies within the organisation. The person who is responsible for a particular overseas market might play more of an entrepreneurial (though not necessarily more important) role than a shopfloor worker.

89

90

CHAPTER 16

LAND AND CAPITAL

To~lc Summa~ Economists define land to include the surface area of the planet, including seas, lakes, rivers and the mountains. It also includes all ores and mineral deposits as well as fish in the seas, lakes and rivers, wildlife in the woods, and so on. Capital, on the other hand, is any asset which is created for use in production. Because of this capital goods are often referred to as producer goods.. For convenience economists distinguish between fixed capital which is durable and is used time and again in the production process, and circulating capital which can only be used once. Circulating capital consists of such items as raw materials, semifinished goods, finished goods held in stock and so on.

Mobility of Land Land is perfectly immobile geographically in the short run and the long run. It is impossible to move Mount Kilimanjaro or the North Sea to a different location. Other factors of production might be immobile in the short run, but no other factor of production is geographically immobile in the long run to the same extent as land. Again in the short run we might expect land to be occupationally immobile. It takes time to convert arable land to building land. However, even in the long run, some parts of land might be occupationally immobile. What else could the North Sea or the peaks of the Himalayas be used for except fishing and mountaineering?

Characteristics of Land

As a factor of production land has certain characteristic features, some of which are also common to other factors of production.

Zero Cost of Production Since land is regarded as a free gift of nature it has no cost of production. It is not created by the efforts of any living individual. It is true that human effort can improve the quality of land and its resources, but its actual creation is not the result of any human input. This characteristic is not unique to land. Unskilled labour also has zero cost of production.

The accumulation of capital depends on abstention from current consumption, which is the phrase most often used to describe the sacrifice involved in capital accumulation. Abstention from current consumption implies that in order to accumulate capital it is necessary for the community to save. Remember, a nation only has limited resources and if these are fully employed, and more of these are devoted to producing goods and services for current consumption, less will be available for producing capital goods. When the community saves, resources are released from current consumption and these resources are then available for the production of capital goods. Saving therefore makes capital accumulation possible but it does not guarantee that it will take place. Capital accumulation, as we shall see in Chapter 21, is determined by many factors. All we are saying here is that without saving there is no possibility of capital accumulation.

90

CHAPTER 16

LAND AND CAPITAL

To~lc Summa~ Economists define land to include the surface area of the planet, including seas, lakes, rivers and the mountains. It also includes all ores and mineral deposits as well as fish in the seas, lakes and rivers, wildlife in the woods, and so on. Capital, on the other hand, is any asset which is created for use in production. Because of this capital goods are often referred to as producer goods.. For convenience economists distinguish between fixed capital which is durable and is used time and again in the production process, and circulating capital which can only be used once. Circulating capital consists of such items as raw materials, semifinished goods, finished goods held in stock and so on.

Mobility of Land Land is perfectly immobile geographically in the short run and the long run. It is impossible to move Mount Kilimanjaro or the North Sea to a different location. Other factors of production might be immobile in the short run, but no other factor of production is geographically immobile in the long run to the same extent as land. Again in the short run we might expect land to be occupationally immobile. It takes time to convert arable land to building land. However, even in the long run, some parts of land might be occupationally immobile. What else could the North Sea or the peaks of the Himalayas be used for except fishing and mountaineering?

Characteristics of Land

As a factor of production land has certain characteristic features, some of which are also common to other factors of production.

Zero Cost of Production Since land is regarded as a free gift of nature it has no cost of production. It is not created by the efforts of any living individual. It is true that human effort can improve the quality of land and its resources, but its actual creation is not the result of any human input. This characteristic is not unique to land. Unskilled labour also has zero cost of production.

The accumulation of capital depends on abstention from current consumption, which is the phrase most often used to describe the sacrifice involved in capital accumulation. Abstention from current consumption implies that in order to accumulate capital it is necessary for the community to save. Remember, a nation only has limited resources and if these are fully employed, and more of these are devoted to producing goods and services for current consumption, less will be available for producing capital goods. When the community saves, resources are released from current consumption and these resources are then available for the production of capital goods. Saving therefore makes capital accumulation possible but it does not guarantee that it will take place. Capital accumulation, as we shall see in Chapter 21, is determined by many factors. All we are saying here is that without saving there is no possibility of capital accumulation.

91

LAND AND CAPITAL

Common Mistakes to Avoid Land and working capital can sometimes be confused. Land is not just the surface area of the globe. It is defined by economists to include all natural unexploited resources. Thus economists would classify oil in the ground as land, but oil in a pipeline on its way to the refinery would be classified as working capital.

Money and capital are also frequently confused and it is common for people to refer to money as capital. In fact, as we shall see in Chapter 23, money is simply a claim to assets. Money is clearly important in creating the conditions necessary for specialisation. In this sense it is probably the most important invention of all time! However it is not a factor of production. Capital has quite a specific definition. It is any asset which has been created entirely for use in production. Money does not satisfy this definition and is therefore not capital.

REVIEW QUESTIONS AND ANSWERS

Questions 1 Is land a renewable or non-renewable resource? Explain your answer. 2 The Bible tells us to turn 'swords into plough-

shares', and there is much talk nowadays of the 'peace dividend'. What are the practical problems involved in such changes, and how can they be illustrated by the use of a production possibility curve?

3 Is a screwdriver an example of fixed or working capital?

Answers 1 Land is usually defined as 'all the free gifts of nature'. Land therefore includes the surface area of the planet and all its contents such as minerals, ores, forests, the fish in the sea and so on. Given this definition, land is partly a renewable resource and partly a non-renewable resource. For example, we can plant more forests, impose a quota on fish catches to conserve stocks and so on. On the other hand, once minerals and ores have been extracted they cannot be replaced. 2 Turning swords into plough shares implies changing one type of physical asset into capital equipment. The problem is that a great deal of capital is specific and cannot be converted into other uses. In the short run, specific items of capital are completely immobile geographically and it is literally impossible to convert a sword into a ploughshare. However, in the long run, resources can be diverted away from the production of one type of good and can instead be used to produce capital equipment or some consumer good. This is what the term 'peace dividend'

implies. The end of the 'cold war' has released resources away from the production of military equipment and these resources can now be put to other purposes. No doubt you will recognise this as an example of opportunity cost Scarce resources have alternative uses. In the present context, if they are used to produce capital equipment the opportunity cost of this is the consumer goods that might otherwise have been produced. We can see from Figure 16.1 that, as fewer and fewer resources are devoted to the production of capital goods, more and more consumer goods can be produced. However, as more of one good is produced the opportunity cost increases because of diminishing returns. Figure 16.1 A production possibility curve showing the opportunity cost of consumer goods in terms of capital goods

-

Consumer goods

Cspltal goods

3 A screwdriver is an item of fixed capital. Its form does not change, no matter how many times it is used in the course of producing output. Working capital has no fixed form. Raw materials, for example, become semi-finished products and then finished products. These are all examples of circulating capital.

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CHAPTER 17

THE DISTRIB UTION OF FACTOR INCOMES

Topic Summary The Marginal Productivity Theory One approach adopted by economists to analyse the distribution of factor incomes is in terms of the marginal productivity theory. For convenience we concentrate in this chapter on the case of labour but the marginal productivity theory is equally easily applied to other factor markets. In the case of labour the basic question to answer is why some workers, such as footballers, stockbrokers and accountants, earn significantly higher incomes compared to other workers such as cleaners, nurses and typists. The marginal productivity theory is based on the assumption that there is perfect competition in the factor and product markets. In the labour market this implies that workers are price-takers. They accept the wage rate as given and therefore the firm can recruit as many workers as it wishes at the ruling wage rate. Furthermore each worker is regarded as homogeneous and therefore all workers are equally efficient. Perfect competition in the product market implies that the firm sells its entire output at the ruling market price and simply adjusts output so as to equate marginal revenue with marginal cost. The marginal productivity theory predicts that a firm will go on employing additional units of labour until the marginal cost of employing the last worker exactly equals the marginal revenue of that worker. This is simply a restatement of the profit maximisation condition, that marginal cost is equated with marginal revenue, first mentioned on p. 55. However, our aim here is to identify the equilibrium number of workers, not the equilibrium level of output.

The Marginal Productivity Theory Under Perfect Competition Perfect competition in the product market implies that the individual firm is powerless to influence the price at which it sells its product. It simply accepts the market price as given and adjusts output so as to equate marginal revenue with marginal cost. By focusing on the effect of changes in output on the demand for factor inputs, in this case labour, we can identify the firm's demand for labour curve. This is our starting point for an analysis of wage determination under conditions of perfect competition. The contribution of the last worker employed to the firm's revenue is referred to as marginal revenue product. When there is perfect competition in the product market this is equal to marginal physical product multiplied by the price at which the product is sold. In symbols we can write

Where MRPL is the marginal revenue product of labour, MPPL is the marginal physical product of labour and P is the price of the product. In general we would expect the marginal revenue product of labour to rise at first and subsequently to fall as more workers are employed. We know from p. 40 that as firms employ more workers there will be increased scope for specialisation and therefore the firm will experience increasing returns to labour, that is, marginal physical product will at first rise. However, beyond a certain level of employment, increasing returns will give way to diminishing returns, that is, marginal physical product will fall. Since changes in the output of an individual firm have no effect on market price of the product, it

THE DISTRIBUTION OF FACTOR INCOMES

follows that marginal revenue product will vary directly with marginal physical product. Because we have assumed that the firm can recruit as many workers as it wishes at the ruling market wage rate, the wage rate is perceived to be constant and therefore the marginal cost of labour equals the average cost of labour. The firm simply follows the profit maximising condition and equates marginal cost with marginal revenue product to obtain its required input of labour. Figure 17.1 is used to illustrate this. Figure 17.1 The effect of changes in the wage rate on the number of workers employed when there is perfect competition in the labour market and the product market

g

~ 0.. ~

c:

~

w

4

The Demand for Labour

~ W2 ~ §>

MRP

~

M

M1 ~ Number of workers

In Figure 17.1, MRP is the marginal revenue product of labour and ARP is the associated average revenue product of labour. If the wage rate is OW, the firm will employ OM workers, because this is where marginal cost equals marginal revenue. If the wage rate is OW1 the firm will employ OM1 workers, at OW2 the firm will employ OM2 workers and so on. In other words, the firm's MRP curve below its ARP curve is its demand for labour curve! Given the MRP curve, we can read off how many workers will be demanded at any given wage rate.

Criticisms of the Marginal Revenue Productivity Theory 1

3

firm's demand for labour curve but it takes the wage rate as given. It tells us nothing about how the wage rate is determined. In the real world firms do not operate in perfectly competitive markets. In particular the supply or workers to an organisation is unlikely to be perfectly elastic. Indeed in some cases wages are negotiated by powerful trade unions. The marginal revenue productivity theory is based on the assumption that firms aim to maximise profit, but organisations in the public sector, for example, might not always aim to maximise profit. Furthermore, as we have seen on p. 87, firms might pursue other goals. Even if firms do aim to maximise profit they are unlikely to possess the precise knowledge of marginal revenue and marginal cost to enable them to adjust employment so as to equate marginal revenue with marginal cost.

The Market Theory of Wages

w,

0

2

93

The marginal productivity theory under conditions of perfect competition is a partial theory of wage determination. It enables us to derive the

Although the marginal productivity theory was originally conceived as a theory of income distribution under conditions of perfect competition, our analysis of wages is easily adapted to the more realistic conditions of the real world. In the product market under imperfect competition the firm must reduce the price of its product in order to increase sales. In this case marginal revenue product will rise less steeply and fall more steeply than under perfect competition because the fall in price as sales increase will reduce the effect of increasing returns on marginal revenue product, whereas it will increase the effect of diminishing returns on marginal revenue product. However the general shape of the marginal revenue product curve is unchanged whether we consider perfect competition in the product market or imperfect competition in the product market. We can therefore assume that, in the real world, the demand for labour by an individual firm will be inversely related to the wage rate. Furthermore, by summing horizontally, or adding together, each individual firm's demand for labour curve we can derive a market demand for labour curve.

The Supply of Labour In the real world the market supply of labour increases as the wage rate increases. The main

94

INTRODUCTORY ECONOMICS COURSE COMPANION

reason for this is that as the wage rate increases workers will be attracted away from alternative occupations.

Detennination of the Wage Rate The market theory of wages explains wage determination as the result of the interaction of supply and demand for labour as illustrated in Figure 17.2. Figure 17.2 The equilibrium wage rate in a particular labour market

----------------~

0

M

direction. If all other things remain equal, an increase in productivity will increase marginal revenue product because at any given level of employment the firm will now have a greater volume of output to sell. Again the effect of an increase in productivity will therefore be to shift the firm's MRP curve vertically upwards at any given level of employment. The effect of a change in demand for labour is illustrated in Figure 17.3. Figure 17.3 The effect of a change in demand for labour on the wage rate and the number of workers employed in a particular labour market

D Number of workers

0

In Figure 17.2, SS and DD are the free market supply and demand curves for labour. The equilibrium wage is OW and OM workers are employed at the equilibrium wage. Once equilibrium is established in this labour market there will be no reason for either the wage rate or the number of workers employed to change unless there is a prior change in the conditions of supply and/or demand.

Changes in the Demand for Labour We can identify two broad reasons why the demand for labour might change; each is summarised below.

•

•

If the demand for the product which labour produces changes, there will be a change in the demand for labour in the same direction. If all other things remain equal, an increase in demand for the product will cause an increase in the price of the product. As price rises, marginal revenue product will rise and the whole MRP curve will shift vertically upwards at any given level of employment. If the marginal product of labour changes, the demand for labour will change in the same

M

M1

o,

Number of worlcers

In Figure 17.3, SS is the supply curve of labour to an industry. If DD is the initial demand curve for labour then a shift in the demand curve to D1D1 represents an increase in the demand for labour. On the other hand, if D1D1 is the initial demand curve for labour then a shift in the demand curve to DD represents an decrease in the demand for labour. It is clear that an increase in the demand for labour will result in an increase in the wage rate (from W to W1) and an increase in the number of workers employed (from M to M 1) while a reduction in the demand for labour will result in a reduction in the wage rate (from W1 to W) and a reduction in the number of workers employed (from M1 to M).

Changes in the Supply of Labour A major factor affecting the supply of labour to an occupation is the existence of barriers to entry. These might take many forms and the removal or erection of barriers to entry will affect the supply of labour to an occupation. For example, if one of the professional

95

THE DISTRIBUTION OF FACTOR INCOMES

organisations, such as the Institute of Chartered Accountants, raises its entry requirements, over time this will reduce the supply of chartered accountants. On the other hand, if the ability of a trade union to enforce a closed shop is removed this will increase the supply of labour because firms will be able to employ both union and non-union workers. Measures to improve mobility of labour will also affect the supply of labour. Increased provision of training schemes will increase the occupational mobility of labour and, through this, the supply of labour. Similarly measures to increase geographical mobility will increase the supply of labour. Figure 17.4

er. The ability of a union to influence the pay and conditions of its members depends on several factors. Here we take the simplest case, where the union controls the entire supply of labour to an employer. In these circumstances a union has considerable ability to fix wages but it must be aware that any increase in wages might affect the number of workers employed. Figure 17.5 is used as a basis for illustration. Figure 17.5 The effect of a union on wages and employment in a particular labour market

The effect of a change in the supply

0

of labour on the wage rate and the number of workers employed in a particular labour market 0

01

5

5 5

0

01

Wf-------~

~ WI f-----"""?'L--+-7((

t

5 0

0

M M1

Number of workers

In Figure 17.4, DD is the demand curve for labour to an industry. If 55 is the initial supply curve for labour then a shift in the supply curve to sl sl represents an increase in the supply for labour. On the other hand, if 5151 is the initial supply curve for labour then a shift in the supply curve to 55 represents a decrease in the supply for labour. It is clear that an increase in the supply for labour will result in a decrease in the wage rate (from W to W1) and an increase in the number of workers employed (from M to M1) while a reduction in the supply of labour will result in an increase in the wage rate (from W1 to J.V) and a reduction in the number of workers employed (from M 1 to M).

The Effect of a Union For many workers wages are negotiated between their trade union and representatives of their employ-

0

M1

M

Number of workers

In Figure 17.5, 55 and DD are the free market supply and demand curves for a particular type of labour. The equilibrium wage is OW and OM workers are employed. Now if a union demands a wage increase of WW1 and refuses to supply any workers at a wage below OW1, the supply of labour curve is now effectively given by W1FS. The new equilibrium is owl. but if all other things remain equal the number of workers employed in the industry will fall to OM1. It is doubtful whether this reduction in employment will be acceptable to the union. To obtain the higher wage and yet simultaneously avoid any redundancies among its members, the union must persuade employers in the industry to increase their demand for labour. In Figure 17.5, if demand for labour shifts to D1D1 the union will achieve its objective of a higher wage without any reduction in the numbers employed. There are various options available to the union. One solution is for the union to increase productivity of the workforce. If all other things remain equal an increase in productivity will increase marginal revenue productivity, and this in turn will cause an

96

INTRODUCTORY ECONOMICS COURSE COMPANION

increase in the demand for labour. It is for this reason that pay awards are sometimes linked to changes in working practices or the introduction of new equipment. A different strategy is to persuade an employer to finance the pay award by raising the price of the product. Again, if all other things remain equal this will increase the marginal revenue productivity of labour and therefore the demand for labour will increase. The ability of the union to persuade employers to increase product prices will partly depend on the elasticity of demand for the products. The union of course cannot control this. A longer term strategy is for the union to insist on longer periods of training before workers are qualified to enter an occupation. If successful this will cause a reduction in the supply of qualified workers and, as we we have seen on p. 95, as the supply of workers falls, the wage rate will rise.

Elasticity of Demand for Labour A crucial determinant of the effect of a change in supply of labour on the wage rate and the numbers employed is the elasticity of demand for labour. There are three main factors which influence elasticity of demand for labour in a particular occupation.

effect on the demand for labour will also be relatively small.

The Substitutability of Capital for Labour The elasticity of demand for labour is directly related to the ease with which capital can be substituted for labour. When capital and labour are close substitutes, even a relatively small increase in labour costs might cause a more than proportionate reduction in the amount of labour demanded. The more labour costs increase, the more elastic will be the demand for labour because it will become more and more economic to substitute capital for labour.

Elasticity of Supply of Labour Just as the elasticity of demand for labour is important in identifying the effect of a change in the supply of labour on the wage rate and the numbers employed, so the elasticity of supply is important in identifying the effect on the wage rate and the numbers employed of a change in demand for labour. We can summarise the main determinants of elasticity of supply of labour to a particular occupation.

Elasticity of Demand for the Product The elasticity of demand for labour is directly related to the elasticity of demand for the product that labour produces. If demand for a good is relatively elastic, then a change in the price of that good will cause a proportionately greater change in quantity demanded. If the increase in price is caused by an increase in wages, as the quantity of the product demanded falls, there will also be a proportionately greater fall in the quantity of labour demanded.

Labour Costs as a Proportion of Total Costs The elasticity of demand for labour is directly related to the proportion of total costs which are made up of labour costs. When labour costs account for a small proportion of total costs, then even a relatively large increase in labour costs will cause only a relatively small change in total costs. In such cases the effect of an increase in labour costs on the final price of the product will be relatively small and therefore the

Length of Training Elasticity of supply will vary directly with the length of training required for entry to an occupation. Some occupations, such as doctors and architects, require a lengthy period of training and so have a relatively low elasticity of supply. Other occupations, such as window cleaners and builders labourers, require little or no training and so have a relatively elastic supply.

Natural Ability Elasticity of supply will vary directly with the degree of natural ability required to enter an occupation. In some cases, such as footballers and actors, it is easy to recognise the high degree of natural ability required to enter an occupation. However, a high degree of natural ability is also required to become an accountant or solicitor. When a high degree of natural ability is required by an occupation, elasticity of supply will be lower.

THE DISTRIBUTION OF FACTOR INCOMES

Mobility of Labour Elasticity of supply will vary directly with the degree of mobility of labour. The more occupationally and geographically mobile the labour force, the more elastic the supply of labour to an occupation.

Economic Rent Economic rent is the surplus a factor of production earns over and above its transfer earnings. Transfer earnings are the minimum reward necessary to keep a factor of production in its present occupation. For any factor of production, if actual earnings fall below transfer earnings then that factor of production will transfer to its next most well paid occupation. The concept of economic rent is illustrated in Figure 17.6. Figure 17.6 &onomic rent earned by a factor

of production

s

D

z 0

97

are transfer earnings and no economic rent is earned. At the other extreme, when the elasticity of supply of a factor of production is perfectly inelastic it has no transfer earnings and therefore its total earnings, whatever they happen to be, consist of economic rent. It is important to note that any factor of production can earn economic rent. For example, it is likely that the earnings of most soccer stars consist of economic rent. Similarly, since normal profit can be regarded as the opportunity cost of the entrepreneur, the supernormal profit of the monopolist consists of economic rent. In the case of capital, the earnings of circulating capital might be close to its transfer earnings but this is unlikely to be true of a great deal of fixed capital which is likely to have few, if any, alternative uses!

Profit Profit is the reward to the entrepreneur. Normal profit is the minimum acceptable reward if the entrepreneur is to remain in the industry in the long run. Normal profit is therefore a cost of production, but in practice, because normal profit is a vague concept that cannot be measured, profit is treated as a residual, that is, the amount left over after all other costs of production have been met. There are various ways in which profit can be measured, depending on the purpose for which profitability statistics are required.

D

Profit as a Residual Q

Number of unHs employed

In Figure 17.6, ZS and DD are the supply and demand conditions for a factor of production. The equilibrium price is OP and the quantity employed in equilibrium is OQ. However only the last unit of this factor employed receives its transfer earnings. Every other unit would be willing to work for an amount less than OP. Apart from the last unit employed, every other unit of this factor receives economic rent and the total amount of economic rent earned is equal to the area PYZ. The amount of economic rent earned by any factor of production is determined crucially by its elasticity of supply. When elasticity of supply is perfectly elastic, the entire earnings of a factor of production

The simplest measure of profit is simply total revenue minus total cost. Thus if total revenue is £1m and total cost is £0.8m, profit is £200000.

Profit as a Percentage of Turnover Profit is sometimes expressed as a percentage of turnover or total revenue. Thus, if total profit is £200 000 and total revenue is £1m, profit as a percentage of turnover is £0.2m/ £1m = 20 per cent.

Profit as a Return on Capital Profit is sometimes expressed as a percentage return on capital assets. Thus, if total profit is £200 000 and the value of capital employed is £2m, the return on capital employed is £0.2m/£2m = 10 per cent.

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INTRODUCTORY ECONOMICS COURSE COMPANION

Common Mistakes to Avoid A common mistake, frequently made in examinations, concerns the marginal cost of employing an additional worker. Remember, the marginal cost of an additional worker is simply the change in the total wage bill when one more worker is employed. For example, if a firm employs 10 workers at a wage of £300 per worker and, in order to attract one more worker it is necessary to increase wages to £310, the marginal cost of the last worker is (£310 x 11) - (£310 x 10) = £410. In other words the marginal cost of the last worker is £410 - not £310! Sometimes there is confusion over the accountanfs notion of profit and the economisfs notion of profit. To the economist, normal profit is a cost of production. It is the minimum acceptable return to the entrepreneur for bearing the uninsurable risks of production. Anything in excess of normal profit is supernormal profit. To the accountant, profit is simply the difference between total cost and total revenue. Accountants have no use for the concept of normal profit and in their calculations they do not even recognise its existence! Economic rent, as we have seen on p. 97, is the amount a factor of production earns over and above its transfer earnings. However not all economic rent will be earned in the long run. Sometimes economic rent disappears in the long run. For example, the supernormal profit earned by firms in perfect competition in the short run is economic rent which disappears in the long run. Such economic rent is referred to as quasi-rent.

Questions and Answers _______. Questions 1 Outline the factors which determine the structure of wages in the economy. Explain whether or not there are any economic reasons why, despite equal pay legislation, on average women are paid less than men in Britain. ]MB, 1991

2 A trade union is likely to be in a favourable position to influence wages when its members 1 2

are employed in relatively few production plants work in production systems where capital costs are a high proportion of total costs

are employed making products which the employers sell in competitive markets A 1, 2 and 3 are correct B 1 and 2 only are correct C 2 and 3 only are correct D 1 only is correct E 3 only is correct ULEAC, Jan 1992

3

3 A rise in wages in a particular industry would be likely to produce unemployment in conditions where the supply of alternative factors is elastic labour costs form a high proportion of total costs 3 the marginal cost of labour rises above marginal revenue product A 1,2 and 3 correct B 1 and 2 only correct C 2 and 3 only correct D 1 only correct AEB, June 1991 1 2

Answers 1 The structure of wages in an economy refers to the existing pattern of wage differentials between workers in different occupations. Some groups, such as coal face workers in mining receive relatively high wages while others, such as agricultural workers, receive relatively low wages. The differences are accounted for by differences in the conditions of supply and demand in the different labour markets. It is normally argued that the demand for labour will be inversely related to the wage rate. One reason for this is that, after a certain level of employment, each additional worker will make a smaller and smaller contribution to total revenue because of diminishing returns. Because of this, in any given occupation, firms will be willing to employ more workers only if the wage rate falls as employment increases. On the other hand, the supply of labour to an occupation will vary directly with the wage rate. As the wage rate rises in an occupation, more and more workers will offer themselves for employment in that occupation. The reason is simple. As the wage rate in one occupation rises relative to other occupations, workers will be attracted away from lower paid occupations. The implication is that, in any particular labour market, and for the labour market as a whole, supply and demand curves will be the normal shape. Figure

99

THE DISTRIBUTION OF FACTOR INCOMES

17.7 shows a typical labour market where DD is the demand for labour and SS the supply of labour. In this market the equilibrium wage rate is OW and OM workers will be employed at this wage rate.

Figure 17.7 The equilibrium wage rate in

a parlicular ltJbour market

----------------~

s

D

0

Number of workers

This explains how the wage rate is determined in a typical labour market, but it does not explain the structure of wages within an economy. In fact the structure of wages is determined by differences in the conditions of supply and demand in different labour markets. In particular there are considerable differences in the elasticity of demand and supply for different groups of workers. If we consider two distinct labour markets, for surgeons and for window cleaners, the importance of differences in the elasticity of supply and demand will be apparent. In the case of surgeons a specialist skill is sold on the labour market. Society places a tremendous value on this skill. After all, the surgeon saves lives and eases pain and suffering, all of which society is prepared to pay dearly for. Furthermore there are no substitutes available for the surgeon's skill so that demand for surgeons is relatively inelastic. Supply will also be relatively inelastic. It requires a relatively high minimum level of academic ability, a cool head under pressure and a steady hand to become a surgeon. Even if someone does possess these skills, it takes several years to train as a surgeon. The supply of surgeons will therefore be relatively inelastic. This contrasts markedly with the market for window cleaners. For most people a window cleaner is a convenience which saves many people having to perform a tedious and thankless chore. However

having someone else clean our windows is hardly a necessity and if the price rose significantly many people would simply clean their own windows. The demand for window cleaners is therefore relatively elastic. Similarly window cleaning is classed as unskilled work, which implies that it is possible for almost anyone to undertake the work after only the briefest amount of training. There are certainly no entry requirements, though to clean some windows a head for heights is necessary! We can illustrate the effect of different elasticities of supply and demand on wages in different labour markets. In Figure 17.8, 55 55 and D5 D5 represent the supply and demand conditions for surgeons, while SwSw and DwDw represent the supply and demand conditions for window cleaners. Note the relatively inelastic demand for surgeons compared with window cleaners, representing the greater value society places on the work of surgeons compared to window cleaners. The supply of surgeons is also relatively inelastic compared with the supply of window cleaners because of the time taken to acquire the skills of a surgeon compared with window cleaning, where little or no training is necessary.

Figure 17.8 Equilibrium in two different ltJbour

markets

Sw Dw 0

Ms

Mw

The inevitable result of these supply and demand conditions is the relatively high reward received by surgeons (W5 ) and the relatively low reward received by window cleaners (Ww). More generally, differences in supply and demand conditions in each of the different labour markets largely explain the structure of wages in the economy.

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INTRODUCTORY ECONOMICS COURSE COMPANION

In the real world other factors might also affect the wage received by certain groups. In particular it is sometimes alleged that discrimination might affect the wages of women and ethnic minorities. It is difficult to be certain about the extent of this but there is no doubt that on average in the UK female earnings are about one third less than male earnings. However this does not necessarily imply discrimination and the difference in average earnings can be explained, at least partly, by economic reasons. Typically the marginal productivity in occupations dominated by female workers is below that in occupations dominated by male workers. This is mainly due to the fact that women tend to work in labour-intensive occupations where the impact of capital, and especially changes in technology, have little effect on the productivity of labour. Workers who are able to work with modem equipment are able to raise productivity compared with other groups and so are able to secure higher pay awards. Investment in human capital is also an explanatory factor accounting for the pay differential between male and female workers. On average women undertake less training than men and their relatively poor performance in the pay league therefore partly reflects a differential between skilled and unskilled workers. There might be many reasons why women undertake less training than men, but the fact that they do adversely affects their pay. There might also be an indirect effect. Men are more likely to be promoted into better paid positions, again perhaps reflecting a higher level of training compared with their female counterparts. The problem of low pay might be compounded for married women who have historically been less mobile geographically than men. Again there might be many reasons for this, not all of them economic, but the effect is to depress the pay of women in the labour market because lack of mobility prevents them from moving to better paid jobs. Family commitments often restrict the opportunity for women to participate fully in the labour market. We therefore find that most part-time jobs, which tend to carry a relatively low wage, are filled by women. Another possible factor accounting for the relatively low pay of women is the fact that a smaller proportion of women are members of a trade union than male workers. In addition, many of those who are union members belong to unions which are

relatively weak, such as those in clothing and retailing. The effect of trade unions on the proportion of national income going to labour is unclear but powerful unions might be able to affect the distribution of labour's share of national income. 2 If workers are employed in relatively few production plants they will be in a stronger bargaining position than when they are employed in a relatively large number of production plants. There are many possible reasons for this. In large organisations there is likely to be greater scope for specialisation and economies of scale which will tend to reduce labour costs as a proportion of total costs. We explain the importance of this in the next paragraph. The first statement is therefore correct. When capital costs form a large proportion of total costs then, by definition, labour costs form a small proportion of total costs. In such cases an increase in labour costs has a relatively small effect on total costs. This is a relatively favourable situation for a trade union because it implies that an increase in wages has a relatively small effect on final price. The second statement is therefore correct. When products are sold in competitive markets a small increase in price might adversely affect sales. In such a case a trade union has less ability to influence the wages of its members. Statement 3 is therefore incorrect. The key is B. Statements 1 and 2 only are correct. 3 When the supply of factors of production is elastic it will be relatively easy to substitute capital for labour. An increase in wages in these circumstances will almost certainly lead to unemployment of labour. The first statement is therefore correct. When labour costs form a high proportion of total costs, a rise in labour costs will cause a relatively large rise in the price of the product. In consequence, quantity demanded will fall and fewer workers will be required to produce the product. The second statement is therefore correct. When a wage increase results in the marginal cost of labour rising above the marginal revenue product of labour, the firm will be employing too many workers for profit maximisation. The effect of a wage increase in such circumstances will be to reduce the numbers employed. The third statement is therefore correct. The key is A. Statements 1, 2 and 3 are all correct.

101

THE DISTRIBUTION OF FACTOR INCOMES

REVIEW QUESTIONS AND ANSWERS Figure 17.9 Lorenz curves of income earned

Questions 1 Why is the productivity of the average American worker likely to be higher than that of a worker in Russia? 2 A trade union negotiates a wage rate which is greater than marginal revenue product. Use a diagram to illustrate that not all members of the union can expect to benefit from this in the long run. How might an increase in productivity alter this diagram? 3 For a time in the late 1970s and early 1980s some airlines stopped training new pilots. Use supply and demand analysis to predict how the wages of pilots subsequently altered during times of increased economic activity. 4 Are the promoters of a recital by Pavarotti able to pay the artist high wages because of the high ticket prices they can charge for admission, or are they forced to charge high ticket prices because of the artist's ability to command high fees? 5 Explain why land prices are much higher in New York City than on the plains of the American mid-west.

and earners

G

-=--------

umulative.:..:.1:..:. 00

y. of

ncome earned

0

100 CumulatiVe %of earners

IK::::=--L-----___J

6 Examine the two Lorenz curves A and B in Figure 17.9. Which of these Lorenz curves shows a more unequal distribution of income? Carefully justify your answer. 7 A person inherits £50,000 and uses it to buy a shop. At the end of the first financial year an accountant finds that sales receipts were £40,000 and costs were £36,000 and reports

Table 17.1 Male and female earnings and employment 1973

Occupational group

1988

Female-male Proportion of Male earnings, Female-male Proportion of Male earnings as % of average differential• as % of average female differential• female employmentt male eamingst employmentt male eamingst

Clerical and related Selling Catering, cleaning, etc. Materials processing: excluding metals Making and reparing: excluding metal, electrical Processing, making and repairing: metal, electrical Repetitive assembling and related Transport operating, storage and related All identified occupations

70.7 46.0 72.4

49.0 7.8 14.5

103.6 111.5 76.3

80.2 55.9 82.5

59.2 8.4 12.5

109.0 127.3 77.4

63.1

3.9

95.9

68.4

22

94.8

58.5

8.4

104.8

66.2

6.4

98.6

61.5

4.1

105.9

69.6

2.0

104.1

612

10.6

70.5 65.7

1.6 100.0

100.7 89.7 100.0

72.8

8.2

79.9 79.1

100.0

1.1

93.5 87.9 100.0

Notes: *Average hourly earnings (excluding overtime pay and overtime hours) of adult women in full-time employment as percentage of average hourly earnings of adult men in full-time employment. t Females in occupational group as % of all females in identified occupations. t Male hourly earnings in occupational group as % of average male earnings in all identified occupations.

Source: Department of Employment.

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INTRODUCTORY ECONOMICS COURSE COMPANION

that profits were therefore £4,000. Explain why an economist might not agree that this represents a true picture of the shop's profitability.

8 Suppose that a local firm were negotiating a wage deal with a trade union, and asked you as an economist for advice. Write a report showing how economic theory might be relevant to the negotiations.

9 Examine the figures in Table 17.1 (on p. 101). (a) What are the difficulties involving comparing male and female wages? (b) Why do women tend to have inferior pay to men? Are these reasons purely economic? (c) can legislation improve the wages of women? Does the data support the view that the Equal Pay Act of 1970 has been effective?

Answers

Figure 17.10 The effect of a wage increase on

the number of workers employed with and without an increase in productivity

g ~ 0.. ~

c:

~

~

"'

w~

~ w & "' :r; 0

Figure 17.11 The effect on the wage rates of pilots of a change in supply and a change in demand for airline pilots

1 There are many reasons for the differences in productivity. The main factor is undoubtedly that workers in the USA work with more advanced and efficient capital equipment than their counterparts in Russia. Workers in the USA are also likely to be better educated, better fed and generally healthier than workers in Russia. Motivational factors might also be important. For example workers in the USA are more likely to receive bonus payments as a reward for increasing productivity than are workers in Russia.

2 In Figure 17.10, MRP represents the firm's initial marginal revenue product curve. The existing wage rate is OW and in equilibrium the profit maximising firm employs OM workers. If a trade union is able to negotiate a wage increase above the rate currently paid, for examand all other things remain equal, the ple, to number of workers employed will fall to OM1. However, if the union is also able to increase productivity, then MRP will shift to MRP1. In this case the union might be able to negotiate a wage increase of WW2 with no reduction in the number of workers employed.

wl.

3 In Figure 17.11, SS and DD are the original supply and demand curves for airline pilots. The original wage rate for airline pilots is therefore W.

M1 M Number of workers

s 0

D

Number of airline pilots

A reduction in the number of airline pilots trained will, over time, result in a shift in the supply curve to S1S1. If all other things remained equal this would cause an increase in the wages of pilots to W1. However, if increased economic activity also leads to an increase in air travel, perhaps because more people take holidays abroad as a result of increased prosperity, the demand for pilots will increase, shown by the shift in the demand curve to D1D1, and wages will rise to Wz.

THE DISTRIBUTION OF FACTOR INCOMES

4 The ticket prices for a Pavarotti concert, like all other prices, are determined by supply and demand. The demand to see an artist like Pavarotti is such that demand for tickets to see any of his concerts will be relatively high, whereas the number of places will be limited. Consequently ticket prices will be relatively high. The same reasoning explains the ability of Pavarotti to command the fees he does. 5 The explanation is simple. Sites in New York City command higher prices than sites on the plains of the mid-west because there is a higher demand at any given price for such sites. In turn, the higher demand is explained by the fact that New York City offers access to millions of consumers, whereas the plains of the mid west are more remote. Sales would therefore be greater for a firm located in New York City and this explains the difference in site values. 6 Curve B shows a more unequal distribution of income than curve A because curve B shows that a greater proportion of the population earn a smaller percentage of total income than illustrated by curve A. 7 An economist would also consider the opportunity cost of using the £50 000 inheritance. For example, it might have been deposited in a building society, in which case it would earn interest. In using the money to buy a shop, interest is forgone and this is why an economist and an accountant would have different views on the level of profit earned in the first year. 8 There are many factors that might be considered here. Local conditions in the labour market would be relevant to a trade union, especially if there was a labour market shortage. Another factor that might be highlighted is the willingness of the workforce in cooperating with the introduc· tion of new equipment or changed working practices aimed at increasing productivity. When productivity increases, firms can increase the wage rate without necessarily increasing their costs of production. A trade union might also stress the level of profit earned by the organisa-

103

tion since the last pay award and the contribution of union members in raising profit. Changes in the cost of living in the area might also be relevant, especially when this exceeds the national average, as it might do in London and the south east. These points could be linked to the potential loss of workers to rival firms or other parts of the country if pay demands are not met. 9 (a) A major problem with such comparisons is that differences in pay are often based on differences in the type of work performed. In addition, comparisons of this nature take average wages and this might mask considerable differences between workers in one organisation compared with workers in another organisation. (b) There are many possible reasons. Women often seek part-time employment to coincide with school hours. They are often more willing to accept employment in the low paid jobs because they are not the main household earner and have often sacrificed their own careers so as to run a home and raise a family. They often lack strong union representation. These are clearly economic factors accounting for wage differences but discrimination might also account for differences in pay. Women might very well be discriminated against when applying for more highly paid jobs or when there are opportunities for promotion. They might also be discriminated against if employers are less willing to train female workers because they fear they will withdraw from the labour market to raise a family. In fact many women now combine a career with an active family life and it is hoped that this kind of discrimination will disappear. (c) There is no doubt that equal pay legislation can improve the position of women by making it illegal to offer different rates of pay for the same work purely because of gender differences. The narrowing of the female differential in the table we are given clearly indicates that the relative position of women has improved between 1973 and 1988. However the existence of the differential suggests that discrimination still exists. If this is correct the most effective long term solution is to change attitudes.

104

CHAPTER 18

NATIONAL INCOME AND ITS MEASUREMENT

Topic Summa National income statistics provide a summary of a nation's economic activity. This information is necessary for the formulation and implementation of economic policy as well as in determining quotas, such as contributions to the EC budget, and the allocation of economic aid to less developed countries.

Defining_ National Income At its simplest, national income is a measure of output produced in a given period, usually one year. The main official measure of national income in the UK is gross national product (GNP). However, this is not the value of output produced within the UK. The total value of output using resources located within the UK is gross domestic product (GDP). The difference between GNP and GDP is due to income paid on resources owned by residents of one country, but which are located in another country. Such incomes are referred to as property income because they are derived from the ownership of property. They take the form of interest rent, and dividends and the difference between inflows and outflows is referred to as net property income paid abroad. Despite the fact that GNP is the main official measure of national income, the term 'national income', is usually taken to refer to net national product (NNP). The difference between GNP and NNP is depreciation of capital. Deducting depreciation simply recognises the fact that not all of the capital equipment which is produced in a given period adds to the nation's stock of capital. Some is used to replace capital that has become obsolete over the accounting period.

Measurin the National Income The Income Method This approach to calculating national income is based on the fact that the value of goods and services produced must be exactly equal to the value of incomes paid to the factors of production which have produced them. Factor incomes consist of income from employment, income from self-employment, interest, rent and profit. Again we must add net property income from abroad to obtain GNP and deduct depreciation to obtain NNP. The main problem with computing national income in this way is the need to avoid including transfer payments. These are simply payments made as part of a redistribution of income rather than as payment to a factor of production in return for its contribution to output. Transfer payments include pensions and social security payments to the unemployed.

The Expenditure Method The expenditure method of calculating national income is based on the fact that whatever is produced must either be sold or added to stock. All that is necessary is to add up the value of final expenditures on domestic output plus any domestic output which is added to stock or consists of work in progress. We have stressed the importance of domestic output because some expenditure of UK residents will be on imports, including imports of raw materials and other components. Since national income is defined as national output, expenditure on imports must be deducted from total expenditure when calculating national income. This calculation will yield GDP. However not all expenditure undertaken by residents is paid to the factors of production, some is paid to the government

105

NATIONAL INCOME AND ITS MEASUREMENT

in the form of taxation. To obtain the amount received by the factors of production we simply deduct from final expenditure the amount paid in indirect taxation and add on any government subsidies. This is because subsidies reduce the market price of goods and services so that the amount received by the factors of production exceeds the market price paid by consumers by the amount of the subsidy. After these adjustments have been made we have GDP at factor cost. If we add on net property income from abroad we have GNP at factor cost and deducting depreciation from this aggregate gives

NNP.

A possible problem with this approach is to ensure that we distinguish between a change in the value of stock due to a rise in prices, which does not add to national income, and a change in the value of stock caused by a change in the amount of stock held, which does add to national income.

ratio that prices have increased between the two years that we wish to compare. The following example illustrates the general principles involved. (Note that an index of prices simply shows the percentage increase in prices of a specified basket of goods and services- see Chapter 27.)

Year 1

2

Nominal GNP(£m) 300000 350000

Index of prices

To change nominal GNP in year 2 to GNP at constant year 1 prices we simply reduce nominal GNP in year 2 in the ratio that prices have increased between year 1 and year 2. Thus we have: £350 000 x 100/110

=

£318181.8m (approx).

From this we can calculate the percentage increase in real income. Thus we have: (£18181.8m - £300 OOOm) x 100

The Output Method When national income is measured by the output method we simply add the value of all goods and services produced within the UK to yield GDP at market prices. Again, if we wish to obtain GDP at factor cost we simply deduct indirect taxes and add on subsidies. Adding net property income from abroad gives GNP at factor cost and deducting depreciation gives NNP. The main problem with this approach to calculating national income is the need to avoid double counting, that is, counting the same output twice. For example, if we include the total output of the steel industry and the total output of the coal industry we will be including the value of the coal used to produce steel twice. To avoid double counting we must either add the final value of output or the value added at each stage of production.

Changes in Real GNP

-----

Nominal GNP is simply GNP at current market prices, whereas real GNP refers to the volume of output produced (plus net property income from abroad). The main causes of a change in nominal GNP are changes in the prices of goods and services due to inflation and changes in the volume of output a nation produces. To measure changes in real GNP we need to eliminate the effect of inflation on nominal GNP. To do this we measure GNP at constant prices. This simply means that we reduce nominal GNP in the

100 110

6 per cent (approx).

Problems with Comparing the Standard of Living The most common measure of the standard of living is GNP per head or GNP per capita. This statistic is the basis of most official comparisons of the standard of living, whether we compare one year with another year or one country with another country. Despite its widespread use, there are several limitations of using per capita GNP for purposes of comparison.

Inflation When comparing the standard of living at different points in time it is important to ensure that we use GNP at constant prices rather than GNP at current prices. If we did not, then comparisons of GNP per capita would be misleading. For example, if there was a rise in prices but no change in population, using nominal GNP to compare living standards implies that the standard of living would increase each time prices increased!

The Distribution of Income If there is an increase in per capita GNP at constant prices, this does not necessarily imply that for most

106

INTRODUCTORY ECONOMICS COURSE COMPANION

people the standard of living has increased. For example, if the distribution of income becomes less equal, then the increase in per capita GNP at constant prices might imply that a relatively small number of people have significantly higher real incomes while for the majority of the population real income is either unchanged or only slightly changed.

of living has increased. Similarly, if there are differences in the level of externalities imposed on the population in different countries, comparisons of per capita income will give a misleading indicator of relative living standards.

Leisure Time

When there are differences in the volume of output provided on a 'do it yourself basis comparisons of per capita income will give an inaccurate estimate of the standard of living. Anyone painting their own house or growing their own vegetables produces an output which is unrecorded in estimates of GNP. Where there are differences in the amount of work undertaken on a DIY basis, either from one year to the next or from one country to another, comparisons of per capita income will distort the true difference in the standard of living.

An important determinant of living standards is the availability if leisure time. Even when per capita income at constant prices between two periods or two countries is constant, the standard of living will differ if there has been a change in the numbers of hours worked or the number of annual holidays awarded to the workforce. This is a particular problem when making comparisons between developed countries and less developed countries because the latter are usually characterised by vast inequalities in the distribution of income.

Composition of Output Changes in per capita income might inaccurately reflect changes in living standards because there have been important changes in the range of goods and services produced. For example, in recent years the 'peace dividend' has released resources from the production of military equipment which are now available for the production of goods and services which more directly affect the standard of living. In other words, although the value per capita income may not change between two periods, the standard of living may differ if the composition of output changes. Similarly, if there are differences in the composition of output between two countries, per capita income will not necessarily provide a reliable indicator of living standards.

Externalities All measures of GNP per capita are based on market prices but these omit all externalities. If society loses the use of some amenity as a result of production or consumption then the measured value of GNP per capita will underestimate its true value. For example, if a chemical factory dumps its toxic waste into a river and kills all the fish, then those who use the river, such as anglers, bear part of the cost of production. In other words, if negative externalities increase, an increase in per capita GNP at constant prices does not necessarily imply that the standard

Self-provided Commodities

The Underground Economy A great deal of economic activity is unrecorded because those involved do not deelare their earnings so as to avoid payment of taxes. The existence of the underground economy reduces the accuracy of GNP statistics and adds to the problem of making meaningful comparisons of per capita income. For example, if the size of the underground economy changes from one period to the next or differs between countries, comparing per capita income will not accurately reflect relative living standards.

Common Mistakes to Avoid GDP and GNP are frequently confused. The former is simply the value of output produced within a nation's borders. It takes no account of the ownership of resources used in production. GNP, on the other hand, measures the value of incomes received by a nation's population. The difference between these two aggregates is explained on p. 104. Another general problem is to recognise which

activities make a contribution to measured national income. In general, an activity makes a

contribution to measured national income if we can identify an output, an expenditure and an income. For example, if someone cleans their own windows, an output is produced but there is no expenditure on this output and certainly no income is received from supplying it. On the other hand, if a window cleaner is employed the same output is produced but now we

NATIONAL INCOME AND ITS MEASUREMENT

can also identify an expenditure (the householder pays the window cleaner) and an income is received (the householder's expenditure is the window cleaner's income). There are exceptions to this rule- for example, an estimate is included of the rental value of owner-occupied dwellings - but, in general, the rule is reliable.

Questions and Answers Questions

------------------~

1 (a) Distinguish between the cost of living and the standard of living. (b) Examine the factors likely to improve the standard of living either in the UK or in a country of your choice over the next ten years. ULEAC, january 1992 Questions 2 and 3 are based on the following information about different aggregates . for an economy during the course of a particular year. Consumers' expenditure Gross investment Government final expenditure Taxes Subsidies Imports Exports Net property income from abroad Depreciation

£m

3500 500 950 375 100 175 250 20 190

The following options apply to questions 2 and 3 below. A B C D E

£5045m £5025m £4855m £4770 £4580

2 Which one of the above options gives the value of GNP at market prices?

3 Which one of the above options gives the value of net national product?

Answers 1 (a) The cost of living refers to the quantity of goods and services which can be purchased with a

107

given amount of money. If we take a typical basket of goods, then, as the price of those goods in the basket rises, the purchasing power of money will fall. In this sense, there has been an increase in the cost of living because goods and services now cost more. In the UK, the Index of Retail Prices is sometimes referred to as the 'cost of living index' because it measures changes in the price of a specific basket of goods and services which are bought regularly by the average household. The standard of living is a vague concept bound up with notions of the quality of life. Economists attempt to measure the standard of living in various ways, such as the number of qualified doctors per head of population or the amount of income the average family spends on food. However, it is recognised that the most important determinant of the standard of living is the level of consumption achieved by the average family. As an approximation to this, economists rely on GNP per head, or per capita income as a measure of the standard of living. Despite its limitations such as the fact that it takes no account of inequality in the distribution of income and wealth, GNP per capita does provide a reasonable approximation to the standard of living. After all, the higher GNP per capita the lower the proportion of income that is devoted to basic necessities, and the greater the proportion that can be devoted to other areas that affect the quality of life, such as health care. (b) In the UK, a major factor that is expected to increase living standards over the next ten years and beyond is the completion of the Single European Market in 1992. The main effect of this was to liberalise trade within the EC. Over time this will increase the scope for competition, specialisation and trade within Europe and the UK, along with all other EC countries, will benefit from this. The Cecchini Report estimated that the benefits of creating a single market might be as high as 5 per cent of Community GDP. To the extent that the UK shares in these gains, living standards in the UK will rise. In the 1980s the UK, along with many other countries, introduced policies of privatisation and deregulation. The former returned public sector assets, such as the electricity generating boards, to the private sector, while the latter opened up markets to competition by removing legal barriers which prevented the emergence of competition. Both policies are expected to encourage increased productivity into the future. There is already some evidence that, because privatised industries place more emphasis on profit than public sector organisations, thete has been an increase in productivity. Similarly it has

108

INTRODUCTORY ECONOMICS COURSE COMPANION

been argued that, by encouraging competition, deregulation has led to increased efficiency. The gains from privatisation and deregulation will continue into the future as firms are forced to seek further improvements in efficiency. They will certainly have a favourable effect on living standards over the next ten years. One major development that will have an important effect on living standards in the UK is the end of the 'cold war' and the 'peace dividend' released as a result. It is now no longer thought necessary to maintain such high levels of expenditure on the armed forces and therefore more resources will be available for the production of those goods and services which are directly consumed by the population. Of course, whether the end of the 'cold war' will result in a higher level of consumption depends on whether the resources released are put to some productive use! Another factor that will have an important bearing on the standard of living in the UK is the rate at which output in the rest of the world grows. The UK is an open economy and if the world, and in particular Europe, is in recession the demand for UK exports will be depressed and this will reduce output and employment in the UK. If world output is rising rapidly, demand for UK output will increase and this will have a positive effect on the standard of living over the next ten years. To some extent, therefore, the growth of living standards in the UK over the next ten years will depend on developments in the rest of the world, and in particular Europe, since this is the UK's major export market. Over the next ten years the output of oil from the North Sea will decline and therefore the UK will become more dependent on imports of oil. The implication is that to maintain the same levels of oil consumption it will be necessary to cut back on imports of other goods and services, or to increase exports. In both cases there will be an adverse effect on the standard of living because of the implied cut in domestic consumption. It might be possible to economise on the consumption of oil, and to some extent the standard of living in the UK over the next ten years depends on this. The greater the reduction in oil consumption, the lower the negative effect of declining North Sea output on the standard of living. Another important factor that affects future living standards is investment, which increases the size of the capital stock. In this context it is important to distinguish between capital widening and capital deepening. The former refers to an increase in the size of the capital stock during a period of rising population such that the amount of capital per

worker is unchanged. In these circumstances the standard of living is unlikely to increase because productivity is unlikely to change. On the other hand, capital deepening occurs when the rate of investment is such that there is an increase in the stock of capital per worker. Given the productivity of capital, this will make possible an increase in output per head and will therefore lead to an improvement in living standards. After all, the more we produce per head, the more we can consume per head! In the UK, as in any other country, if investment outstrips population growth, the standard of living will rise. However, even if the ratio of capital to population is constant, if technological progress is rapid the standard of living may improve because of the higher productivity derived from investing in the latest technologies. Productivity is also influenced by the efficiency with which the labour market functions. In this context education and training of the labour force are important determinants of future productivity. The UK has implemented a series of educational reforms and training initiatives throughout the 1980s and into the 1990s which will no doubt have some influence on productivity and living standards. It is also recognised that taxation, and in particular rates of income tax, can have an important effect on incentives. If there is a connection, then if the government achieves its aim of reducing income tax there will be a favourable impact on living standards over the next ten years. Despite the importance attached to levels of material consumption it is increasingly recognised that other factors make an important contribution to living standards. In recent years the impact of externalities on the environment has attracted increasing attention. We are now very aware of the effect of sulphur dioxide emissions by motor vehicle exhausts and power stations which bum fossil fuels. Sulphur dioxide emissions are a major cause of acid rain which pollutes rivers, lakes and forests. The environment is an important amenity and its loss imposes a cost on society which must be set against any gains from increased output. Past emissions of sulphur dioxide, and other pollutants such as CFCs, by the UK and other countries, will continue to have a negative effect on living standards over the next ten years through their detrimental effect on health. However, if action is taken now to reduce atmospheric pollution by UK based firms, this will cause a reduction in living standards over the next ten years in the UK because it will increase the production costs of firms in the UK and this implies a reduction in real income. The major benefits of such

109

NATIONAL INCOME AND ITS MEASUREMENT

a policy would occur in the longer term. Given the increased awareness of environmental issues it seems likely that the UK, along with many other countries, will enact legislation designed to reduce pollution. The effect on living standards will depend on how severe this legislation is. Clearly there are many factors that will influence the standard of living in the UK over the next ten years. Any action which affects the allocation of resources or the growth of productivity will affect the standard of living. However, there are also many non-quantifiable variables that have an important bearing on living standards. Such factors as the increased availability of leisure time, improved medical knowledge and the incidence of negative externalities are all important determinants of the 'quality of life'. Progress in all of these areas is expected in the UK over the next ten years and this

will have a favourable effect on the standard of living. 2 GNP = GDP + net property income from abroad. = C + I + G + X- M + net property income from abroad

= £3500m + £500 + £950 + £250m £175m + £20m = £5045m

Option A is correct. 3 NNP = GNP at market prices - taxes + subsidies - depreciation = =

£5045m - £375m + £100m - £190m £4580

Option E is correct.

REVIEW QUESTIONS AND ANSWERS

Questions 1 When will GNP > GDP? 2 Can personal disposable income ever be greater than GNP?

3 You are given the following information about a particular economy.

Year 1 2

Nominal income (£m) 100000 120 ()()()

Index of

prices 100

llO

4 Which of the following are transfer payments? A soldier's pay while serving abroad? A gambler's winnings? A student's grant? A son's earnings while employed in his father's business?

5 The following data refer to the UK economy in 1984 (all figures are in £m) Income from employment Depreciation Total domestic expenditure at market prices

18937 3304 91736 91852 52578 7797

(a) What is meant by the term 'total domestic expenditure at market prices'? (b) What is the value of (i) GDP at market prices; (ii) GNP at market prices; (iii) NNP at factor cost?

6 Why are leisure time and externalities impor-

What has happened to real income over the period shown?

(a) (b) (c) (d)

Rent Net property income from abroad Exports Imports Taxes on expenditure Subsidies

180342

38371

391470

tant in estimating the standard of living?

7 Apart from estimates of per capita income,

how else might we compare living standards of people in different countries?

Answers 1 GNP = GDP + net property income from abroad. When net property income from abroad is positive, that is, when property income paid abroad is less than property income received from abroad, GNP will be greater than GDP.

2 Personal disposable income is simply GNP + transfer payments - direct taxes and national insurance contributions. Personal disposable in-

11 0

INTRODUCTORY ECONOMICS COURSE COMPANION

come will therefore be greater than GNP if transfer payments are greater than direct taxation and social security contributions. This implies that the government borrows to finance transfer payments.

3 In year 2 national income at year 1 prices is £120 OOOm x 100/110 = £109 090.9m. Real income has increased by about 9.1 per cent, that is, the percentage change in national income at constant prices. 4 A trarisfer payment is simply a transfer of income from one party to another which is not made in respect of any economic activity. On this definition a gambler's winnings and a student's grant are transfer payments. 5 (a) Total domestic expenditure is simply total

spending by domestic residents on domestic output. It therefore excludes import expenditure and earnings from exports.

(b) (i) £391354m (ii) £394658m (iii) £311 506m.

6 Most estimates of the standard of living simply take the average income per head as a guide to the average level of consumption. However the number of hours worked also affects the standard of living. If the average income in two countries is the same but one country has twice as much leisure time as the other, the standard of living will differ because leisure time has value. Similarly, if the average income in two countries is identical but one country has relatively little pollution compared to the other, the standard of living will again differ because of differences in the quality of life associated with a lower level of pollution. 7 Sometimes estimates of the number of doctors per head or levels of literacy are used. Sometimes an estimate of the number of hours of work required to earn sufficient to buy a given basket of goods is used. Sometimes the extent of home ownership is used. These are important indicators of the standard of living but the most widely used measure is still per capita income.

111

CHAPTER 19

THE DETERMINATION OF NATIONAL INCOME

In chapter 18 the emphasis was on measuring national income. In this chapter and Chapter 20 we examine one model of income determination. The model is sometimes referred to as the Keynesian model after the economist, John Maynard Keynes, who created the model.

The Two-sector Model For simplicity it is usual to consider how national income is determined in an economy which consists only of firms and households. In this economy total spending will consist of spending by the households on consumption (C) and spending by firms on investment (!). That part of income which households do not spend is saving (5). Let us consider each in turn.

Consumption It is usually argued that consumption expenditure has two components: an autonomous component and an induced component. Autonomous consumption spending represents the basic minimum that consumers will spend on such items as food and clothing. This basic minimum is completely inelastic with respect to income. Induced consumption spending represents consumption that is determined by changes in income. In other words, a rise in income induces a rise in consumption expenditure and vice versa. Because there is an autonomous and an induced component of consumption, the consumption function is usually expressed in the form

C =a + bY where a and b are constants.

The extent to which consumption changes as a result of an increase in income is determined by the value of b. In fact b is referred to as the marginal propensity to consume (MPC) which is given by the formula:

MPC

=

!!.C/!!.Y

where: !!.C = change in consumption and !!.Y change in income. We shall see later that the marginal propensity to consume plays an important part in our analysis of income determination.

Investment In the real world there are many factors that influence the rate at which firms invest and we consider these in Chapter 21. In the present chapter and Chapter 20, we make an important distinction between planned investment and unplanned investment. Planned investment, as the term suggests, is simply the amount firms plan to invest during the next period. For simplicity we assume that this is exogenous, that is, it is unrelated to changes in income and can therefore be treated as a constant. However additions to stock are also classed as investment and the amount that will be added to stock in the following period cannot be determined beforehand since in part it depends on the amount firms sell. When actual or realised investment is greater than planned investment then unplanned investment has occurred.

Saving Saving is that part of income which is not spent on consumption by households. We noted earlier that the consumption function is given by

C =a+ bY

INTRODUCTORY ECONOMICS COURSE COMPANION

11 2

and therefore the savings function is given by

S = -a + (1-b)Y Note that, whenever a is greater than (1-b)Y, saving will be negative; economists refer to this as dissaving. Since b is the marginal propensity to consume (1- b) must be the marginal propensity to save (MPS), that is, the rate at which savings change as income changes. The marginal propensity to save is given by the formula

MPS

=

!lSj!lY

Leakages and Injections In the simplest models of the circular flow of income all income earned by households is spent on consumption and all output produced by firms is for consumption by households. This, of course, is a highly unrealistic abstraction from the real world, but it does enable us to classify any expenditures other than consumption expenditures by households as injections into the circular flow of income, and any incomes paid out by firms which are not spent on consumption as leakages. In the two-sector model of the economy there is one injection, investment, and one leakage, saving.

falling until planned output is again brought into equality with planned expenditure. The economy will also be in equilibrium when planned injections are equal to planned leakages. It is easy to show, using simple algebra, that realised saving will always equal realised investment:

Y=C+I Y=C+S I= S

However this equality does not imply that planned savings always equal planned investment. In fact planned savings will only equal planned investment when the economy is in equilibrium. Consider what will happen if planned investment is greater than planned savings. In these circumstances planned output will be greater than planned expenditure and output will therefore rise in the following period. Alternatively if planned investment is less than planned saving, planned output will be less than planned expenditure and output will fall in the following period. Only when planned investment equals planned savings will income be in equilibrium. This is illustrated in Figure 19.1. Figure 19.1

-----

The equilibrium level of income Ct/

c

The Equilibrium Level of Income The equilibrium level of national income exists when there is no tendency for income to change. Equilibrium can only exist when planned output by firms exactly equals planned expenditure. If planned expenditure exceeds planned output there will be unplanned disinvestment in stocks. On the other hand, if planned output is greater than planned expenditure, there will be unplanned investment in stocks and firms will cut back on the amount they produce in the following period. In other words, in this model of income determination, output adjusts to demand, that is, output is demand determined. If planned aggregate demand exceeds planned aggregate supply, firms will adjust their plans and output will go on rising until planned output is brought into equality with planned expenditure. The opposite occurs if planned aggregate demand is less than planned aggregate supply. In this case firms will revise their plans downwards and output will go on

0

~ ·s:: ll!

~ c

~

~

:I 7

y I

t/

/:

y

S

Income (output)

..

Income (output)

In the upper part of Figure 19.1, the 45° line shows all points of equality between realised expenditure and realised output. The graphs C and C + I show the levels of planned expenditure for consumption (C), and consumption plus investment (C + [),

THE DETERMINATION OF NATIONAL INCOME

respectively. It is clear that OY is the equilibrium level of income because only at OY does planned expenditure equal planned output. At any level of income less than OY, planned expenditure is greater than planned output and therefore output will rise. On the other hand, at any level of income greater than OY planned expenditure is less than planned output and therefore output will fall. In the lower part of Figure 19.1, I shows planned investment at all levels of income and S shows planned savings at all levels of income. Again it is clear that OY is the equilibrium level of income. At any other level of income planned expenditure is either greater than or less than planned output so that output will be changing so as to bring them into equality.

Let us assume that in a particular economy we have the following values:

C = £200m + O.BY I= £500m From these values we can derive the equilibrium level of income:

Y = C+ I or in equilibrium I = S £500m = -(£200 Y = £200m+ 0.8Y + £500m

+ 0.2Y) £700m = 0.2Y y = £3500m

The Multiplier It is interesting to see what will happen to the equilibrium level of income in the above example if planned investment increases from £500m to £600m. Now we have:

Y = C+ I or in equilibrium I = S Y = £200m + 0.8Y + £600m £600m = -(£200

= £800m y = £4000m

0.2Y

In fact, following the increase in investment, we can easily calculate the eventual increase in income through the multiplier. It can be shown that the multiplier is equal to 1/MRL, where MRL is the marginal rate of leakage. In this case saving is the only leakage and therefore this general formula for the multiplier reduces to 1/MPS in a two-sector economy. In our example we have

k

=

1/MPS

=

1/0.2 = 5

where k = the multiplier. Given that the value of the multiplier is 5, if investment increases by £100m, income will rise by 5 x £100m, that is, by £500m.

Common Mistakes to Avoid

A Numerical Example

0.2Y = £700m y = £3500m

11 3

+ 0.2Y)

= 0.2Y y = £4000m

£800m

In other words an increase in investment of £100m leads to a fivefold increase in income! Why is this? Note that the MPC is 0.8, so that, when investment increases by £1OOm, income will rise by £100m and households will spend 80 per cent of this, that is, £80m, on consumer goods. This implies a further increase in income of £80m and households will spend 80 per cent of this, that is, £64m, on consumer goods, etc.

One possible problem arises because of the labelling of the Keynesian cross or 45° diagram illustrated in the upper part of Figure 19.1 on. The x axis is labelled Income (output). This reflects the fact that we are concerned with national income and therefore the incomes received by the factors of production are equal to the value of the output they produce. Hence income = output. A more serious problem arises over the interpretation of planned and realised values. Planned values are simply what the different sectors of the economy plan to spend and produce. Realised values are the amounts that the different sectors actually spend and produce. Now there is no reason why planned values should always equal realised values. For example, if consumers change their attitudes and decide to increase the amount they save, firms will be left with unsold goods which they had previously planned to sell. However the important point to note is that, if the plans of any sector (households or firms) are not achieved, these sectors will revise their plans for the next period. In fact plans will be continually revised until they are achieved, in which case planned and realised vales will coincide and the economy will be in equilibrium.

Questions and Answers Questions 1 In a closed economy with no government activity the level of national income rose by £100m as a result of an increase in autonomous injec-

INTRODUCTORY ECONOMICS COURSE COMPANION

11 4

tions of £40m. The marginal propensity to consume in that economy must have been

A

B

c

D

2.5 1.66 0.6 0.4

1 In general, the multiplier can be expressed in the form k = !l.Y/!l], where k = the multiplier;

2 We are given the following information about planned saving at different levels of income in an economy: Income (£) 500m 600m 700m 800m 900m Saving (£) -10 0 10 20 30 We can conclude that in this economy the marginal and average propensities to save are:

APS

falls with income constant rises with income constant rises with income

3 Figure 19.2 shows the consumption function of a country.

Figure 19.2 C(£bn)

Y(£bn)

What could cause the consumption function to shift upwards from C1 to Cz? A B

c

the expectation of an increase in indirect taxation

Answers

]MB, June 1991

MPS A constant B constant C constant D rises with income E rises with income

D

a rise in interest rates a increase in direct taxation the introduction of a 50 per cent deposit for the purchase of goods on credit

!::.. Y = change in income !lj = change in autonomous injections

Substituting the information we are given tells us that in this case the value of the multiplier is 2.5. Now we know that in a closed economy with no government activity k = 1/1-MPC = 1/MPS and by rearranging this we have MPS = 1/2.5. This gives a value of 0.4 for the MPS, which implies that MPC = 0.6. The key is therefore C.

2 For each change in income of £100, savings rises by £10. The MPS will therefore be constant at 0.1. However, as income rises, the proportion of income saved increases. For example, £20/£800 = 0.25, £30/£900 = 0.133 and so on. This implies that the MPS rises as income rises. The key is therefore C. 3 Figure 19.2 shows that when the consumption function shifts from C1 to C2 consumption expenditure increases at all levels of income. Question 3 asks us to identify the cause of this. An increase in interest rates would reduce consumer spending. For example, those with mortgages would have a lower disposable income and the cost of credit would increase, so reducing demand for many consumer durables. Option A is therefore incorrect. Again an increase in direct taxation would reduce disposable income and consumption would fall. Option B is therefore incorrect. The introduction of a minimum 50 per cent deposit for goods bought on credit would mean that many potential consumers would need to increase their savings in order to acquire the deposit. This implies a cut in consumption and therefore option C is incorrect. An increase in indirect taxation such as value added tax would increase the prices of those goods and services on which tax is levied. The expectation of an increase in indirect taxation would therefore encourage consumers to bring forward their decisions on purchases. Option D is therefore correct. The key is option D.

115

THE DETERMINATION OF NATIONAL INCOME

REVIEW QUESTIONS AND ANSWERS

Answers

Questions 1 A hypothetical two-sector economy is initially in equilibrium, with MPS = APS = 0.25Y and investment is £100m. Subsequently MPS falls to 0.2 Y.

1 (a)

Figure 19.3 The effect of a change in the MPS on the equilibrium level of income

(a) Construct a graph to show the original equilibrium level of income and the new equilibrium level of income after the fall in MPS. (b) Why is there no change in investment in response to the decline in planned saving?

500

I l!!

C = 100 + O.BY

I

where C denotes consumption and Y income. The level of investment is 100. Why is 600 not an equilibrium level of income? What is the actual equilibriwn level of income?

Income ( =output)

20 40

20

36

20

20

20

32.8 30.2 20

Consumption goods produced 180 160 144 131.2 80 Consumption goods 160 144 131.2130 80 demanded Exante savings minus exante investment 20 16 12.8 10.2 0

(a) Calculate the MPC and MPS. (b) Explain the process of ajustment which is taking place. (c) What conditions are necessary for equilibrium to be attained?

300 200

100

200

300 400

100

500 600 Output (Income) 5=0.25Y 5=0.2Y I

.~

i

·s~

100

200

300 400

500 600 Oufput (income)

c?l

3 The data below relate to a hypothetical economy for which column 'n' shows the values of the variables when a state of equilibrium has been attained

Exante investment Exante savings

400

100

2 In a hypothetical economy which is initially in equilibriwn, the consumption function is:

Weeks 2 1 4 'n' 3 200 180 164 151.2 100

C1t/ (5=0.2'1? Ct/ (5=0.25'1?

600

(b) The simple answer is that in the Keynesian model investment is assumed to be exogenous and therefore is unrelated to the level of income. However, in terms of the model, when planned saving falls to 0.2Y the equilibrium income rises to £500m; there is no change in the absolute level of savings which is constant at £100m. Since in equilibrium planned savings equal planned investment, this implies that investment will also be constant at £100m. 2 The equilibrium level of income occurs when planned output equals planned expenditure. In equilibrium Y = C + I Y = 100 + O.BY + 100 0.2Y = 200 y = 1000 OR

In equilibrium I

=

S

100 = 0.2Y y = 1000

11 6

INTRODUCTORY ECONOMICS COURSE COMPANION

600 cannot be an equilibrium level of income because planned expenditure exceeds planned output at this level of income. This implies an unplanned reduction in stocks and as a consequence firms will increase output. 3 (a) The MPS can be calculated by dividing the change in saving (~S) by the change in income (~Y) for any relevant pair of values. For example, 40/200 = 0.2 = 36/180 and so on. (b) The process of adjustment illustrated is the multiplier process in a two sector economy. In period 1, planned expenditure is less than

planned output, so that firms cut back on the amount they produce in period 2. Here again planned expenditure exceeds planned output, so that firms again cut back on the amount they produce. This process continues until planned expenditure is brought into equality with planned output. The eventual change in income is a multiple of planned savings, hence the term 'multiplier process'. (c) Equilibrium exists when planned expenditure equals planned output. In a two-sector economy this occurs when planned saving equals planned investment.

117

CHAPTER 20

NATIONAL INCOME DETERMINATION : THE FOUR SECTOR ECONOMY

To~lc

Summary

In the four-sector model of income determination we introduce the government sector and the international sector. In such an economy the equilibrium level of income occurs when planned expenditure equals planned output and in notation we can write

Y

=

Figure 20.1 The equilibrium level of output in a four-sector economy

C + I+ G + X-M

where Y = national income, C = consumption expenditure, G = direct government expenditure on goods and services, X = exports, that is, foreign expenditure on UK output, M = imports, that is, UK expenditure on foreign output. We can also show that equilibrium occurs when planned injections = planned leakages. We know that planned spending = C +I+ G + X- M . We also know that income ( = output) = C + S + T. This implies that C + I + G + X- M = C + S + T, that is,

I+G+X=S+T+M (injections) = (leakages) We can illustrate the equilibrium level of income diagrammatically, as in Figure 20.1 In the upper part of Figure 20.1, AD represents aggregate demand or total planned expenditure at different levels of income. Again the 45° line shows all points of equality between planned expenditure

and planned output. OY is therefore the equilibrium level of income. At any level of income less than OY, planned expenditure will exceed planned output. In this case firms will experience an unplanned reduction in stock and will therefore increase output in the following period. At any level of output greater than OY, firms will experience an unplanned increase in stock and will consequently cut back output in the following period. The economy can therefore only be in equilibrium when national income is equal to OY. In the lower part of Figure 20.1, equilibrium is illustrated in terms of equality between planned injections (I + G + X) and planned leakages (S + T + M). Again it is clear that at any level of income less than OY planned injections are greater than

11 8

INTRODUCTORY ECONOMICS COURSE COMPANION

planned leakages, so that output will rise and at any level of income greater than OY planned injections are less than planned leakages, so that output will fall.

The Multiplier In Chapter 19 we saw that the multiplier was equal to 1/MPS. In the extended Keynesian model discussed in this chapter the multiplier is given by 1/MRL, where MRL is the marginal rate of leakage from gross income. In the full Keynesian model we must take account of the marginal propensity to import (MPM) which is the proportion of any increase in income which is spent on imports, and the marginal rate of taxation (MRT) which is the proportion of any increase in income which is paid in taxation. Thus, if we have the following values, MPS = 0.2Yd, MRT = 0.25 and MPM = 0.125Yd, the marginal rate of leakage from gross income is 0.25(0.8) + 0.2 + 0.125(0.8) = 0.5. The value of the multiplier in this economy would therefore be equal to 1/0.5 = 2.

The balanced budget multiplier shows the effect on income of equal change in taxation and government expenditure. It can be demonstrated that in this case the multiplier has a value of 1, so that income will increase by an amount which exactly equals the increase in government expenditure. For example, assume government expenditure and taxation are both increased by £1000 and the marginal propensity to consume (c) equals 0.8. Now for !lG we have:

!lY __1_ h i ~-~ !lG- 1-c t at s £1000-0.2 that is

11 Y = £5000.

The effect of an increase in taxation on income occurs because the reduction in disposable income causes a reduction in consumption spending. For an increase in taxation we have:

!lY - c!lT . !lY -0.8 !lT =~· that IS, £1000 = ----o.2 that is

!lY = -£4000.

In other words, a simultaneous increase in government expenditure and taxation will result in a final increase in income equal to the increase in government spending, that is, the balanced budget multiplier is 1.

Common Mistakes to Avoid When calculating the multiplier in a four sector economy it is crucial to stress the importance of gross income in calculating the marginal rate of leakage. When we have taxation to consider we cannot simply add together the marginal propensity to save (MPS), the marginal rate of taxation (MRT) the marginal propensity to import (MPM) to derive the marginal rate of leakage because MPS and MPM are marginal rate of leakages from net income, whereas MRT is the rate of leakage from gross income. If MPS and MRT are expressed as functions of disposable income, that is, functions of net income, to obtain the multiplier we must convert these values to functions of gross income, as described above. However, take care when reading a question because MPS and MPM are sometimes given as functions of gross income, in which case they can simply be added together to obtain MRL. The difference is easy to identify. If variables are expressed as functions of Yd, they are functions of net income. If they are expressed as functions of Y, they are functions of gross income. When an open economy with government is in equilibrium we know that planned leakages equal planned injections. However this does not imply that the balances of each individual sector must necessarily be equal. In other words, equilibrium does not require that I = S, G = T and X = M. This condition might exist, but all that is required for equilibrium is that the sum of planned injections equals the sum of planned leakages.

Questions and Answers Questions 1 (a) Examine the factors which influence the size (40) of the national income multiplier. (b) Distinguish between the different multiplier effects of (i) an increase in social security (30) payments, (ii) a cut in the top rate of income tax. (30) ULEAC, Jan 1992

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NATIONAL INCOME DETERMINATION: THE FOUR-SECTOR ECONOMY

2 Figure 20.2 The effect of an increase in investment on income

s

National Income (£m)

(-)

In Figure 20.2, Sis the savings function and / 1 and are different levels of investment. If investment increases from It to / 2 the value of the marginal propensity to consume is represented by

/2

A XY/PQ B PQ/XY C (XY/PQ)-1 D 1-(PQ/XY) E 1-(XY/PQ) ULEAC, Jan 1991

Answers 1 (a) The national income multiplier is simply the ratio of the change in income to the change in injections which brought it about. It can be written as: k

=

!!.Y/M

where 1:!.Y is the final income, M is the change in injections and k is the multiplier. It can be shown that the multiplier will always be greater than 1 and therefore a given change in injections will always result in a more than proportional change in income. An injection is an autonomous change in expenditure and the multiplier effect occurs because any initial change in injections results in a more than proportional change in output and factor incomes. For example, if there is an increase in injections, perhaps because investment increases, output and factor incomes will rise. As factor incomes rise, expenditure will rise and this will generate a further round of increases in output and incomes. However this process will not go on indefinitely because each successive change in expenditure will be less than

the previous change. After all, for the economy as a whole, part of any increase in income will be paid in taxation, part will be saved and part will be spent on imports. In each case part of the income paid out will not be returned to domestic producers in the form of expenditures and so will not contribute to any subsequent rise in income. When injections fall the opposite occurs: income falls, causing a reduction in expenditure and a further reduction in income. At each stage the reduction expenditure is less than the reduction in income because the reduction in income leads to a cut in savings, taxation and import expenditure, none of which contributed to income anyway. The multiplier effect can easily be illustrated. For example, if we assume that the marginal rate of leakage is 0.5, then we know that half of any increase in injections will be spent on additional consumption and half will leave the circular flow of income as a leakage. If we further assume that autonomous investment increases by £100m, we can represent the eventual change in income as the sum of a series diminishing to infinity. The first few terms in this series are £100m

+ £50m + £25m + . . .. .. . .

=

£200m

The first term (£100m) is the initial change in injections and the subsequent terms are the induced changes in consumption that result from the increase in income. In this case the multiplier has a value of 2, that is !!.Y/I:l] = £200m/£100m = 2. The eventual change in income following a change in injections will depend on the size of the multiplier and this, in turn, depends on the rate at which income is withdrawn from the circular flow at each stage. The rate of withdrawal is the sum of the marginal propensity to save, the marginal rate of taxation and the marginal propensity to import. The greater the rate of withdrawal, the smaller the size of the multiplier because the smaller the proportion of income returned to producers following an increase in income, and vice versa. This is easily demonstrated since the value of the multiplier is equal to 1/MRL where MRL is the marginal rate of leakage from the circular flow of income. Thus if MRL = 0.4, the value of the multiplier is 2.5. If MRL = 0.5, the value of the multiplier is 2 and so on. The size of the marginal propensity to save will depend on many factors. For example, a rise in the rate of interest might encourage an increase in saving. If this happens the value of the multiplier · will fall. A change in expectations might also have an effect. If there is a widely held view that inflation

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INTRODUCTORY ECONOMICS COURSE COMPANION

will rise in the future, this might encourage an increase in present consumption which implies a reduction in the marginal propensity to save. In this case the value of the multiplier would rise. Another factor to consider is that in the initial stages of a recession there is some evidence that those in employment increase the amount they save to bolster consumption in the event of redundancy. In other words, the onset of recession might be associated with a rise in the marginal propensity to save and therefore with a fall in the value of the multiplier. The rate of taxation is another major determinant of the size of the multiplier. Taxation is a leakage from the circular flow of income and therefore the greater the amount paid in taxation, the smaller the proportion of income that is returned to producers and therefore the smaller the value of the multiplier. Import expenditure is another important leakage from the circular flow of income and the greater the marginal propensity to import, the smaller the value of the multiplier. There are several factors that might influence demand for imports and in the UK the marginal propensity to import is thought to be relatively high, perhaps as great as 30 per cent. In the case of the UK, foreign competitors often have an advantage in terms of design, delivery, after sales service and so on. A change in any of these factors will change the marginal propensity to import and therefore the value of the multiplier will change. (b) (i) Social security payments are a transfer payment; that is, they represent transfers of income from some members of society to other members of society. The recipients of transfer payments experience an increase in disposable income and, depending on their marginal propensity to consume, will spend part of this increase in disposable income. The proportion of disposable income spent on domestj.c output will generate an increase in national income and, as noted above in the answer to part (a), if all other things remain equal, the final change in income will depend on the marginal rate of leakage. However all other things might not remain equal and the net effect of a change in transfer payments depends partly on how these transfer payments are financed. If they are financed by an increase in taxation then there will be an offsetting reduction in expenditure. In this case the net effect of the increase in social security payments depends on the marginal propensity to consume of those who receive transfer payments relative to the marginal propensity to consume of those who pay higher taxes. In fact, because those in receipt of social security payments are likely to be on lower incomes

than taxpayers, it is likely that the former will be greater than the latter, so that national income will rise. On the other hand, if transfer payments are financed by an increase in government borrowing the effect on national income will be greater. Because those in receipt of social security payments will be on lower incomes they will have a relatively high marginal propensity to consume. When the government finances increased social security payments by borrowing it simply increases the disposable income of those receiving social security payments by using the community's savings. Since savings are not part of the circular flow of income, the net effect of the increase in social security payments is determined entirely by the proportion of social security payments which is spent. Because this is likely to be relatively high, the effect on national income will also be relatively high. (ii) The effect on national income of a cut in the top rate of income tax is likely to be less than the effect of an increase in social security payments. When there is a cut in taxation there is an increase in the disposable income of taxpayers. In consequence there will be an increase in expenditure and the size of this increase will depend on the marginal propensity to consume domestic output of those whose tax has been cut. In fact it seems reasonable to assume that those who pay the highest rate of taxation will have a higher marginal propensity to save than other groups in society. Because of this a relatively large proportion of any reduction in the top rate of income tax will be saved. The multiplier effect of a cut in income tax might therefore be relatively low. It will certainly be less than the multiplier effect of an increase in social security payments, where the majority of the increase in disposable income will be spent. , Another factor to consider is the proportion of income spent on imports and goods which are themselves taxed. Those on higher incomes are likely to spend relatively more on imported goods and services than those on lower incomes. Many imports, such as new cars, automatic washing machines, holidays abroad and so on are outside the budget of many of those who receive social security payments. If, as seems likely, a relatively large proportion of any cut in the top rate of income tax is spent on imports compared with an increase in social security payments the multiplier effect of the former will be smaller than the multiplier effect of the latter. Similarly there are likely to be differences in the type of good that those who pay the top rate of

NATIONAL INCOME DETERMINATION: THE FOUR-SECTOR ECONOMY

income tax consume compared with those who receive social security payments. Specifically, those in receipt of social security payments might consume relatively more goods, such as food, which are not subject to VAT, compared with those who pay the top rate of income tax. To the extent that this is correct the multiplier effect of an increase in social security payments will be greater than the multiplier effect of a cut in the top rate of income tax.

121

2 In a closed economy without government the marginal propensity to consume equals 1- MP5. In turn MP5 is equal to 115/11 Y where 115 = change in savings and 11 Y = change in income. In this case 115 = PQ and 11 Y = XY. MPC is therefore equal to 1-(PQ/XY). The key is therefore D.

REVIEW QUESTIONS AND ANSWERS

Questions 1 Explain the difference between an endogenous variable and an exogenous variable. Using examples from the national income model outlined in this chapter, distinguish between endogenous variables and exogenous variables.

2 How is the equilibrium level of national income determined in a closed economy?

3 The following data refer to a hypothetical economy:

Consumption = 100 + 0.8Yd Investment = 150 Government = 200 Exports = 200 Taxation = 0.2Y Imports = 0.05Yd where Y is the level of national income. (a) Find the equilibrium level of national income, using both the aggregatedemand and injections-leakages approaches. Illustrate your answer with the appropriate graphs. (b) Is there a budget surplus or budget deficit at the equilibrium level of income? (c) Is the balance of trade in deficit or surplus at the equilibrium level of income? (d) What is the value of the multiplier in this economy? (e) If exports increase to 250, what is the new equilibrium level of income? (f) In the original situation, if the government introduced transfer payments by 200, what is the new equilibrium level of income?

4 Why is the balanced budget multiplier equal to 1?

Answers 1 An endogenous variable is a variable determined from within the system. With respect to national income an endogenous variable is one which varies directly with national income such as consumption, savings, taxation and imports. By contrast an exogenous variable is a variable that is determined outside the system. In the case of national income determination this implies that an exogenous variable is one that is unrelated to changes in national income. In the model of income determination outlined in this chapter the endogenous variables are consumption (though this often has an exogenous component), saving, taxation and import expenditure. The exogenous variables are investment, government expenditure on goods and services and export expenditure.

2 The equilibrium level of national income exists when planned expenditure is equal to planned output. If the plans of the different sectors in the economy are not realised they will adjust the amount they plan to spend and produce until all plans are achieved. 3 (a) In equilibrium Y = C + I + G + X- M

Y = 100 + 0.8Yd + 150 + 200 + 200 - 0.05Yd Y = 650 + 0.8Y(1 - 0.2) + 0.05Y(1-0.2) Y = 650 + 0.64Y- 0.04Y 0.4Y = 650

y

=

1625

OR In equilibrium I + G+X = 150 + 200 + 200 = 650 = 650 = 650 =

y

=

S + T +M - 100+0.2Yd+ 0.2y+ 0.05Yd 0.2Y(1 - 0.2)+ 0.2Y+ 0.05Y(1 - 0.2) 0.16Y +0.2Y +0.04Y 0.4Y 1625

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INTRODUCTORY ECONOMICS COURSE COMPANION

(b) The state of the budget is given by G- T. In this case we have: G- T = 200-0.2Y = 200-325. The budget surplus is therefore 125. (c) The balance of trade is given by X- M. In this case we have:

X-M = 200 -0.05Yd = 200-0.05 [0.8 (1625)] = 200-65 = 135.

The balance of trade surplus is therefore 135.

(d) k = 1/MRL MRL = MPS + MRT + MPM. MPS = 0.2(0.8) = 0.16. MRT = 0.2 MPM = 0.05(0.8) = 0.04. MRL = 0.16 + 0.2 + 0.04 = 0.4. k = 1/MRL = 1/0.4 = 2.5. (e) aY = MX aY = 2.5(250) aY = 625 y = 2250

[You can easily check this by substitution in (a) above.]

(f) Government spending only adds directly to national income when it is spent on goods and services. Transfer payments are simply transfers of income from one group to another. They add to disposable income but they do not add directly to national income. However any increase in spending by those who are in receipt of transfer payments will add to national income because this will represent additional spending on goods and services. In this case disposable income rises by 200 and consumers will spend 80 per cent of this, that is, 160, on output. National income will therefore rise by k x 160 = 400. 4 The balanced budget multiplier is equal to 1 because any increase in government spending on goods and services leads to an increase in national income. However an equivalent increase in taxation does not lead to an equivalent reduction in national income because part of any increase in taxation will be financed by a reduction in saving. To the extent that this happens we are simply replacing one leakage with another leakage and the net effect on national income of this is zero. Only that part of taxation which is financed by a cut in expenditures reduces national income.

123

CHAPTER 21

INVESTMENT

To~lc

SummaiJ

Investment is the creation of real physical assets whose only function is to make possible further production. Investment is therefore a flow and the greater this flow the greater the change in the capital stock. As we shall see in Chapter 36, it is usually argued that increases in the capital stock are a major source of improved living standards. Economists are therefore very interested in what determines the flow of investment.

Discounting to Present Value Discounting to present value (DPV) is a technique used to assess the present value of a stream of income received in the future and/or a stream of costs paid in the future. DPV is important because the returns on investment usually accrue over several years into the future. However the costs of the investment will normally be met early on in its life. The problem is that a pound received now is worth more than a pound received in the future if only because it could be placed in a bank deposit, on which interest would be earned. Similarly costs incurred earlier in a project's life are greater in real terms than the same costs incurred later in the project's life. We therefore need a technique for comparing future revenues with present and future costs. Discounting to present value can be thought of as the opposite of interest rate compounding. For example, if £100 is invested for two years at a rate of interest of 10 per cent per annum, the value of the investment will rise to £110 (£100 x 1.1) after one year and to £121 (£110 x 1.1) after two years. This is the same as £100 x (1.1) 2. Similarly, if we are offered £121 in two years' time, we can use our interest rate of 10 per cent as a discount rate to calculate the present value of £121 in two years' time. In this case we have £121/(1.1)2 = £100.

We can see the importance of this if we consider the following example. Assume a firm is considering buying a machine for £250 000 and it will pay for it in full immediately. Assume further that the machine has a life expectancy of three years, after which its scrap value is expected to be £10000. The net annual returns, that is, the annual returns after all operating costs have been met, are expected to be:

£100000 £90000 £70000

Year 1 Year 2 Year 3

If we simply subtract the cost of the machine from the expected net returns, the investment looks profitable, that is, (£100000 + £90000 + £70000 + 10 000)- £250 000 = £20 000. However the cost of the machine is incurred now, whereas the returns accrue in the future. If the appropriate rate of discount is 10 per cent, we can use this to obtain the present value of future returns. Thus we have: DPV = £100000 + £90000 + £70000

(1.1)

(1.1) 2

(1.1) 3

+ £10000 (1.1) 3

= £225394.

Once we reduce future returns to present value we can see that in this case buying the machine would not be profitable. DPV techniques are clearly superior to simply adding together expected returns and subtracting this from costs when deriving an estimate of expected profit. However there are major problems with DPV techniques. It is extremely difficult to estimate future returns and this becomes more difficult the further into the future we look. It is easier to estimate the return on a project with a life of one year than on a project with a life of ten years. In addition there are problems associated with selecting an appropriate rate of discount. Instead of using a discount rate of 10 per cent in the example above, if we use a discount rate of 4 per cent, purchasing the

124

INTRODUCTORY ECONOMICS COURSE COMPANION

machine would be expected to yield a small profit of £483.6 when discounted to present value. The choice of discount rate can therefore affect the expected profitability of an asset. To a large extent estimating future returns and selecting a discount rate are matters of guesswork. Nevertheless this approach is at least more scientific than making no attempt to estimate the present value of future returns.

Theories of Investment The Accelerator This theory of investment relates changes in investment to changes in the level of economic activity. It seems intuitively obvious that there should be a relationship between investment and real GNP because in order to produce a greater amount of output firms will require a higher level of investment. However the accelerator indicates that changes in GNP might have a more than proportional impact on the rate of investment. An example will make this clear. Assume a capital-output ratio of 2:1; that is, to produce one unit of output per period the firm requires two units of capital, that each unit of capital has a life expectancy of five years and that every year 5 per cent of the capital stock is replaced. Given these assumptions, we can see in Table 21.1 the effect of changes in demand for final output on the rate of investment. In year 1 we are in equilibrium with the capital stock equal to twice the rate of output. However in year 2 demand increases and therefore to produce the higher level of output the firm increases investment. But the rate at which investment increases is much higher than the rate at which output rises. In fact output rises by 10 per cent whereas total investment rises by 200 per cent. In year 3 the rate at which investment increases is again above the rate at which

output rises but in year 4 the level of investment actually falls, despite the fact that output is constant. In year 5 the fall in demand for final output results in a further fall in investment demand. Indeed in year 5 the portion of the capital stock that depreciates is not even replaced. Of all the components of GNP, fixed investment is the most unstable element. The accelerator provides a possible explanation as to why investment demand might fluctuate markedly between periods. However, there are many possible reasons why the accelerator might not operate in the mechanical way outlined here. We have assumed that firms are willing and able to respond to increases in demand for their products. This might not be correct, for several reasons: •

•

•

•

•

The first response of any firm which experiences an increase in demand for its product will almost certainly be to run down stocks of finished goods rather than increase capacity. If firms have excess or unused capacity, an increase in demand will be met by using existing plant and machinery rather than by an increase in investment. Firms might not consider any increase in sales to be permanent. If they do not they are unlikely to increase fixed investment. Instead they are likely to meet increased demand by lengthening waiting lists or introducing overtime or shift working. Firms might not be readily able to alter investment plans because they might be constrained by lack of available plant, such as greater factory space. Similarly they might be unable to obtain additional supplies of capital, especially when resources are fully employed or they are depen· dent on an overseas supplier. Over time technological progress will increase the efficiency of capital so that it may be possible

Taf:ile 21.1

Year

Sales

Existing capital

Required capital

Replacement investment

1 2 3 4

1000 1100 1250 1250 1200

2000 2000 2200

2000 2200 2500

100 100 100 100 0

5

2500 2500

2500 2400

Total Net investment investment

0 200 300 0 -100

100 300 400 100 0

125

INVESTMENT

•

to increase output without increasing the rate of investment. Changes in the rate of interest may lower the profitability of investment from one period to the next. If interest rates rise an increase in sales may not be sufficient to persuade firms to increase their investment in fixed assets, and vtce versa.

Despite this, changes in the rate of investment are related to changes in GNP. However the relationship is unlikely to be of the magnitude illustrated in Table 21.1 and may, at certain times, be quite weak.

The Marginal Efficiency of Investment The DPV technique outlined on p. 123 might be useful for an individual firm in assessing the expected profit from additional investment, but it does not explain the determination of investment in the economy. However the marginal efficiency of investment adopts a different approach to derive a theory of aggregate investment. In this case we estimate future returns but then identify the rate of discount that reduces the present value of these future returns to equality with the cost of additional capital. In other words, we need to identify the rate of discount which makes the present value of expected future returns exactly equal to the cost of investment. The rate of discount which does this is the marginal efficiency of investment. If the rate of discount which achieves this is greater than the existing rate of interest, then, if all other things remain equal, additional investment will be profitable. If the rate of discount which achieves this is less than the existing rate of interest, then, if all other things remain equal, additional investment will be unprofitable. A major problem with this approach is identifying the cost of additional capital. There will be considerable differences in the nature and type of assets bought and therefore considerable differences in their price. We therefore take the market rate of interest as our estimate of the cost of capital. In this situation the equilibrium rate of investment occurs when the discount rate is equal to the market rate of interest. We can construct a hypothetical marginal efficiency of investment (MEl) schedule, as shown in Figure 21.1. In general the marginal efficiency of investment falls as the rate of investment increases. One reason for this is that firms will exploit the most profitable investment opportunities first and there-

fore, as investment increases, the present value of future returns will fall because of diminishing returns. Additionally, as investment increases, a greater volume of final output will be produced and, if all other things remain equal, the price of final output will therefore fall. As the price of final output falls the expected value of future returns will fall.

The effect of a change in MET on the rate of investment

Figure 21.1

...

-g

c ~

Q)

~ 0 .!::: l!!

0

R

~

go Q)

~ ~ Q)

(ij

c .E>

...

ME/

::::;;:

I,

ME/1

Investment

In Figure 21.1 the market rate of interest is R and MEl is the initial marginal efficiency of investment schedule. The equilibrium rate of investment is I. Once this rate of investment is reached there will be no tendency to change unless there is a change in the rate of interest or a change in the productivity of capital. For example, if the rate of interest rises the rate of investment will fall, and vice versa. An increase in technological progress will shift the MEl schedule to MEh and the new equilibrium rate of investment will be / 1. Again there are problems with the MEl as a theory of investment. In particular it is extremely difficult to predict future returns and future rates of interest. A great many investment decisions are long term and changes in the rate of interest will change the cost of capital so that investment that might appear profitable at one rate of interest might not be profitable at a higher rate of interest. Firms may not always be prepared to invest if they suspect interest rates may rise before their investment projects are completed. Similarly it is difficult to estimate future returns, especially when these accrue in the long term, and the MEl schedule is therefore grounded in uncertainty. The less certain firms are of future returns, the less willing they will be to undertake investment projects at any given rate of interest.

1 26

INTRODUCTORY ECONOMICS COURSE COMPANION

Cost-Benefit Analysis Cost-benefit analysis is a technique used to assess the costs and benefits of large scale investment projects such as the construction of the Channel Tunnel. It is commonly used in the public sector where investment projects frequently confer benefits on society which are difficult to quantify. For example, constructing a bypass around a major town benefits road users since they complete their journeys more quickly, but it also benefits town residents since there will be less congestion around the main streets, probably fewer accidents, less damage to the foundations of buildings, a reduction in exhaust fumes and so on. One problem with cost- benefit analysis is identifying all of the relevant costs and benefits. This is an extremely difficult task. Another problem is how to value all of the relevant costs and benefits including externalities. In the example, above what money value would we place on a reduction in road use in the town? Having identified and valued all relevant costs and benefits, they must be discounted to present value to facilitate comparison. We have seen on pp. 124-5 the problems associated with DPV techniques and the same considerations apply here. One point to note in the case of public sector investments is that, if a cost-benefit analysis predicts an excess of benefits over costs, this does not imply that a project should go ahead. It simply implies that society would benefit if the project went ahead. Whether the project actually goes ahead is a political decision. The public sector has limited resources and politicians must decide how these are allocated. Cost-benefit analysis is simply an aid to decision taking.

Common Mistakes to Avoid The accelerator and the multiplier are frequently confused. Remember, from p. 113, that the multiplier is used to calculate the eventual change in income following a change in injections. The accelerator coefficient shows the change in investment that results from a change in income. Of course the two concepts are related. For example, an increase in income will, through the accelerator, generate a more than proportional change in the rate of investment. In turn, an increase in investment will, through the multiplier, generate an increase in income and so on. However this process will not go on indefinitely and at some stage the growth of national income will be insufficient to generate an accelerator effect.

There is a great deal of confusion over the difference between the marginal efficiency of capital and the marginal efficiency of investment. In fact the concepts are related, but the marginal efficiency of investment is a flow concept and relates to the short run, whereas the marginal efficiency of capital is a stock concept and relates to the long run. Remember, net investment is the rate at which the capital stock is increasing. In the short run the equilibrium rate of investment is given by the point on the MEl schedule where the marginal efficiency of investment is equal to the rate of interest. In the long run the equilibrium level of the nation's capital stock is given by the point on the MEC schedule where the marginal efficiency of capital is equal to the rate of interest.

Questions and Answers Questions 1 The accelerator theory suggests that the level of net investment depends on changes in the level of national income. These changes might not occur in practice because: 1

business expectations of profit may be very pessimistic, 2 firms may have considerable spare capacity, 3 the rate of interest may be too low. A 1, 2 and 3 are correct B 1 and 2 only are correct C 2 and 3 only are correct D 1 only is correct AEB, Nov 1990 2 Ways in which government policy may be used to shift the marginal efficiency of capital schedule to the right include: (1) increasing depreciation allowances set against tax liabilities of firms, (2) reducing the supply of money, (3) increasing investment grants to industry, (4) raising the rate of interest. A (1), (2) and (3) only are correct B (1) and (3) only are correct C (2) and (4) only are correct D (4) only is correct E (1) and 4 only are correct ]MB, 1990

3 In economic theory which of the following is NOT regarded as 'investment'?

INVESTMENT

A B C D E

The purchase of stocks of raw materials Construction of new factories and warehouses The building of a Channel Tunnel The purchase of shares on the Stock Exchange Training programmes for schoolleavers

ULEAC, Jan 1990

Answers 1 Profit is an important goal of firms in the private sector. Even if national income is rising, firms will not be persuaded to increase their rate of investment unless they expect investment to be profitable. They may not, for example, if their expectation is that the increase in national income is only temporary. Option 1 is therefore correct. If firms have considerable spare capacity then output can be increased without increasing the rate of investment. In these circumstances the accelerator may not respond as national income rises. Option 2 is therefore correct. A low rate of interest would tend to encourage greater investment. There might be several reasons for this. For example, at low rates of interest the cost of borrowing funds will be relatively low and, in many cases, this will reduce the cost of capital for firms. At low rates of interest demand for many consumer durables will be relatively high and this will increase the expectation of profit. This implies that low rates of interest would tend to encourage the . accelerator effect. Option 3 is therefore incorrect. The key is therefore B.

2 If all other things remained equal, increasing depreciation allowances to set against the tax liabilities of firms would increase the expected net return on capital assets because it would reduce the amount paid in tax. The marginal efficiency of capital schedule would therefore shift to the right if depreciation allowances were increased. Option 1 is therefore correct.

127

If there was a reduction in the supply of money, in the short run at least, this would reduce demand for many goods and services because individuals and organisations would, on average, have less money to spend. This would tend to reduce the expected return on capital assets and would therefore tend to shift the MEC schedule to the left. Option 2 is therefore not correct. An increase in investment grants to industry would tend to reduce the supply price of capital and therefore at any given rate of interest more capital would be demanded than previously. In other words the marginal efficiency of capital schedule would shift to the right. Option 3 is therefore correct. When we construct the marginal efficiency of capital schedule we equate the rate of interest with the rate of discount which reduces expected future returns on capital assets to the supply price of capital assets. An increase in the rate of interest would lead to an upward movement along the marginal efficiency of capital schedule. It would not cause a shift of the schedule and therefore option 4 is not correct. The key is therefore B.

3 Economists define investment as the flow of expenditures devoted to increasing or maintaining the capital stock, plus additions to stock and work in progress. Raw materials are additions to stock and so option A is regarded as investment. The construction of new houses and factories is regarded as fixed investment. They add to or maintain the nation's stock of capital and so option B is regarded as investment. The construction of a Channel Tunnel would add to the nation's infrastructure and so option C is regarded as investment. The purchase of shares on the Stock Exchange simply represents the transfer of assets from one owner to a new owner. There is no increase in the capital stock and therefore option D is not regarded as investment. Training programmes for school leavers represents investment in human capital. Option E is therefore regarded as investment. The key is therefore D.

128

INTRODUCTORY ECONOMICS COURSE COMPANION

Answers

Questions 1 At a market rate of interest of zero, would the level of business investment be infinite? 2 (a) Using economic analysis and the information in Table 21.2, how might you explain observed changes in net fixed investment? (b) What other factors may have influenced the level of net fixed investment in the period shown? 3 The data below refers to a hypothetical investment project with a life of two years and no final resale value. Cash flow year 1 Cash flow year 2 Supply price of project

£1035 £1058 £1600

If the market rate of interest is 15 per cent, determine the viability of the project by estimating: (a) the present value of the cashflows. (b) the net present value of the project; How would your appraisal be affected by a rise in the rate of interest to 25 per cent?

1 The equilibrium rate of investment occurs when the marginal rate of return on investment is exactly equal to the marginal cost of capital. At zero rate of interest investment would continue up to the point at which the marginal rate of return on investment was zero.

2 (a) Net fixed investment refers to additions to the stock of capital. It is therefore investment net of depreciation and excludes additions to stock and work in progress. In general the behaviour of net investment follows the behaviour of GNP at constant prices with a lag of one year. In other words, if GNP at constant prices rises, net investment rises the following year and vice versa. This is illustrated in Figure 21.2. The response of investment to changes in GNP is variable but the data lend support to the notion that there is an accelerator effect associated with changes in real GNP. The variable response of investment to changes in real GNP might also indicate that changes in expectations are important in determining investment decisions.

Table 21.2 Investment and GNP, 1978-88 Year prices 1978 1979 1980 1981 1982 1983 1984 1986 1987 1988

GNP at 1985 prices

Gross investment at 1985 prices

Net fixed investment at 1985

(£b)

(£b)

(%of GNP)

(£b)

(%of GNP)

322.2 331.8 322.4 320.1 325.8 338.8 347.3 358.1 390.1 406.7

54.9 56.4 53.4 48.3 50.9 53.5 58.1 60.3 66.9 75.7

17.0 17.0 16.6 15.1 15.6 15.8 16.7 16.8 17.1 18.6

20.6 21.3 17.0 10.7 12.2 13.6 17.1 18.5 23.2 29.8

6.3 6.4 5.3 3.3 3.7 4.0 5.2 5.0 5.9 7.3

Source: HMSO, UK National Accounts (1989).

129

INVESTMENT

Figure 21.2 The behaviour of investment and GDP £m 420 r -

400

r-

--GOP at1985 mari

1.80

~ c;;

1.70

'E

0

·~

a..

s D

0

Quantity of sterling

In Figure 33.1, DD and SS are the demand and supply curves for sterling and £1 = $1.80 is the equilibrium rate of exchange. Unless there is a change in the conditions of demand or the conditions of supply, no other rate of exchange is

In Figure 33.2 DD and SS are the original demand and supply curves for sterling on the foreign exchange market and the exchange rate is initially £1 = $1.80. Subsequently, if there is an increase in demand for sterling to D1D1 and all other tllings remain equal, sterling will appreciate against the dollar from £1 = $1.80 to £1 = £1.90. A decrease in demand for sterling will have exactly the opposite effect. For example, if D1D1 is now the original demand curve and SS is the original supply curve, the rate of exchange will initially be £1 = $1.90. Subsequently, if the demand for sterling falls toDD and all other things remain equal, the rate of exchange will depreciate to £1 = $1.80.

EXCHANGE RATE SYSTEMS

We can also examine the effect of a change in the conditions of supply. Returning to the original situation with supply and demand represented by 55 and DD and the exchange rate at £1 = $1.80, if there is an increase in supply of sterling to the foreign exchange market from 55 to 5 15 1 and all other things remain equal, sterling will depreciate against the dollar to £1 = $1.70. A decrease in the supply of sterling will have exactly the opposite effect. With supply and demand initially represented by 5 15 1 and DD and the exchange rate initially in equilibrium at £1 = $1.70, a decrease in the supply of sterling to 55 will cause sterling to appreciate against the dollar to £1 = $1.80.

Factors Causing a Change in the Exchange Rate In the real world many factors influence the rate of exchange. In this section we analyse the most important factors but it is important to remember that we assume all other things remain equal in each case.

Relative Inflation Rates In the long run there is no doubt that relative rates of inflation are the most important determinant of a country's rate of exchange. If one country has a higher rate of inflation than its trading partners then, at any given rate of exchange, its exports will become more competitive and its imports will become less competitive. In consequence demand for its currency will fall on the foreign exchange market as export demand falls, and supply of its currency will increase as import demand rises. This will cause the rate of exchange to depreciate against all other currencies. Relative Interest Rates In the modem world funds are highly mobile between currencies and therefore, if all other things remain equal, an increase in the rate of interest in one country relative to interest rates in other countries will cause the exchange rate to appreciate. (Indeed funds are so mobile and information so quickly transmitted that the merest hint that interest rates are about to change can sometimes cause exchange rates to change.) The reason is simple. A rise in interest rates in one country relative to other countries implies a higher return on funds invested in that country. In consequence, if one country increases its rate of interest and all other things remain equal, demand for that country's currency will increase as

195

foreigners take advantage of the higher return. There might also be a reduction in supply of currency as domestic residents now invest at home rather than abroad. The combined effect will be to force the exchange rate upwards.

The Current Account Changes in the state of the current account will also cause a change in the exchange rate. When the current account deficit worsens, the gap between import expenditure and export earnings widens. For the deficit country this implies an increase in supply of its currency and a reduction in demand for its currency, with the inevitable result that its currency depreciates. Expectations When a currency is expected to appreciate, holders of tllat currency make a capital gain if their expectation is correct. For example, if the sterling exchange rate is initially £1 = $1.80 then an investor with $1.80m who expects sterling to appreciate can convert this into £1m. If this expectation proves to be correct and sterling appreciates to £1 = $1.90, then, after appreciation, £1m can be converted into $1.90m - a capital gain of over 5 per cent! Many factors can influence expectations and investors will act upon any new information that becomes available which influences their expectation of future exchange rates. In this sense expectations about the factors discussed above will influence the exchange rate as investors seek to make a capital gain. Thus an expected change in the rate of inflation, an expected change in the rate of interest or an expected change in the size of the current account deficit (surplus) will cause a change in the exchange rate.

Fixed Exchange Rates A fixed exchange rate exists when the authorities stipulate the rate at which their currency will exchange against other currencies. The central bank then intervenes as and when necessary as buyer or seller to maintain the specified exchange rate. The object of intervention is to neutralise changes in supply or demand for currency on the foreign exchange market so that the exchange rate neither appreciates nor depreciates against other currencies. Figure 33.3 is used to explain how intervention stabilises the exchange rate. In Figure 33.3, if DD and 55 are the original demand and supply curves for sterling on the foreign exchange market and the exchange rate is

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INTRODUCTORY ECONOMICS COURSE COMPANION

Figure 33.3 Intervention by the authorities to

maintain a fixed exchange rate

~

:g .J!!

0

2.00

D

s

o,

U)

E

~

s,

1.90

.5 ';::

c

1.80

c;;

1.70

C)

*

0

.§ a..

0

M

N

Quantity of sterling

initially £1 = $1.80. Assume £1 = $1.80 is the agreed fixed parity of sterling against the US dollar. The foreign exchange market is therefore initially in equilibrium. Subsequently, if there is an increase in supply of sterling the supply curve will shift to S1S1. In a free market the exchange rate would depreciate. However, if the authorities are committed to maintaining the rate of exchange at £1 = $1.80, to avoid depreciation they will be compelled to purchase the excess supply of sterling, MN, on the foreign exchange market at this rate of exchange. The demand curve for sterling therefore shifts to D1D1 and downward pressure on sterling is averted. When there is upward pressure on a currency the authorities act in the opposite way to avoid appreciation. It is important to realise that, when the authorities intervene to prevent a currency from depreciating, they are drawing on the official reserves of foreign currency. In terms of Figure 33.3, the reserves of foreign currency fall by MN. Such a policy cannot continue indefinitely because the nation only possesses a limited amount of reserves. In the longer run action will be necessary to remove the need for intervention. The appropriate response of the authorities depends on the cause of downward pressure on the exchange rate. In the long run the main cause of downward pressure on the exchange rate is a higher rate of inflation than that experienced in competing economies. To remove downward pressure on the exchange rate in the long run, the authorities must therefore gear monetary policy to reducing the rate of inflation. One obvious policy measure open to the

authorities is to raise the domestic rate of interest. As we have seen on p. 195, this will attract a capital inflow and will reduce a capital outflow. If the rate of interest is increased high enough it will therefore eliminate the need for direct intervention in the foreign exchange market by the authorities. In the longer run the higher rate of interest will tend to reduce domestic inflation and when this happens interest rates will fall because the cause of downward pressure on the exchange rate will have disappeared.

Advantages of Floating Exchange Rates Automatic Adjustment in the Balance of Payments It is sometimes alleged that the major advantage of floating exchange rates is that they guarantee that the foreign exchange market is in continuous equilibrium and therefore the authorities do not need to gear domestic policy to achieving a stable exchange rate. For example, if the UK has a higher rate of inflation than its trading partners, this will simply lead to depreciation of the sterling exchange rate without the need for any kind of policy to be adopted in the domestic economy. As sterling depreciates export prices abroad will fall and import prices in the domestic economy will rise. As consumers respond to these price changes, supply and demand for sterling on the foreign exchange market will change so as to ensure that the foreign exchange market, and therefore the balance of payments, are in continuous equilibrium. The opposite will happen if UK inflation is below that in other countries. Here the sterling exchange rate will appreciate so as to preserve equilibrium in the foreign exchange market and avoid a surplus in the balance of payments. Despite this bold claim, floating exchange rates do not always eliminate balance of payments surpluses and deficits as smoothly as implied here, since the effect of depreciation depends on such factors as the elasticity of demand for exports and imports, the elasticity of supply of exports, and so on.

Greater Freedom to Pursue Domestic Policy Goals It is alleged that, because floating exchange rates ensure equilibrium in the balance of payments, the authorities have greater freedom to direct domestic

EXCHANGE RATE SYSTEMS

policy to achieving other goals, such as full employment. The argument is that, when governments boost aggregate demand to increase employment, inflation rises and the balance of payments moves into deficit. Since the deficit is self-correcting when exchange rates float, there is no reason to reverse policy. In fact, inflation imposes many costs on the economy and governments would wish to avoid these costs even if floating exchange rates did guarantee that balance of payments deficits were self-correcting! The real problem is that unstable exchange rates make it difficult for firms to plan and encourage inefficiency in the allocation of resources. Because of this it is alleged that floating rates lead to higher, rather than lower, unemployment.

Economy in the Size of Reserves It is argued that under a system of floating exchange rates the authorities will not require such large holdings of foreign exchange reserves, since they will not be required for intervention in the foreign exchange market. The point is that holding reserves imposes an opportunity cost on society because these reserves could otherwise be spent. Here again this is not a strong argument because, if domestic inflation is kept in line with that of a country's trading partners, its exchange rate will be stable and therefore reserves will not be required for intervention purposes.

Advantages of Fixed Exchange Rates Reduced Uncertainty A major advantage of fixed exchange rates is that they reduce uncertainty about costs and returns for those involved in international trade. When export orders are received the exporter knows how much will be received when the contract is fulfilled. Similarly importers know in advance the cost they will incur when entering into particular agreements. If exchange rates float freely then it is much more difficult for the exporter to predict how much will be received from a particular contract because this will vary with the exchange rate. If the domestic exchange rate appreciates, exporters will receive a windfall gain. However, if the domestic exchange rate depreciates, exporters will incur an unanticipated reduction in revenue. There is equal uncertainty for importers. The cost of imports to domestic buyers will change if the

197

exchange rate changes between the time the contract is agreed and the time the contract is fulfilled. For example, if the sterling exchange rate is £1 = $1.80 when an import contract for 1000 units of a particular commodity at $1000 per unit is agreed, the anticipated cost to the importer is £555 555.6. However, if the exchange rate at the time payment is made is£1 = $1.70, the actual cost to the importer is £588 235. When firms import raw materials the cost of final output will be similarly affected by changes in the exchange rate. The higher price might jeopardise sales in the domestic economy and therefore adds to the risks of production. Of course firms can eliminate risk through the forward market but this adds to their costs. Indeed for many small and medium sized firms the cost of forward cover is prohibitive. The reduction in uncertainty that is implied by fixed exchange rates makes it easy for firms to plan their output and investment decisions. This encourages greater efficiency in the allocation of resources and greater productive efficiency in the way firms use resources.

Control of Inflation It has been suggested that a major advantage of fixed exchange rates is that they remove from governments the power to vary money growth for short term political aims. We have seen on p. 163 that the effect of increased money growth in the long run is an increase in the rate of inflation with no effect on real variables such as employment or output. When exchange rates are fixed, economic policy must be directed towards ensuring that inflation is broadly in line with that in other countries. It is suggested that, under a system of fixed exchange rates, inflation in many countries will be lower and therefore the costs of inflation (see pp. 167-8) will be reduced or eliminated altogether.

A Note on Speculation It has been suggested that floating exchange rates deter destabilising speculative capital flows because there is a risk of capital loss, as well as the possibility of capital gain, under floating rates. Under a fixed exchange rate system speculators have a one-way option. Thus, if a currency is weak against other currencies and the authorities have failed to deal with the cause, then devaluation, that is, a reduction in the exchange rate to a lower fixed parity, looks increasingly likely.

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INTRODUCTORY ECONOMICS COURSE COMPANION

Under these circumstances investors can move their funds out of the domestic currency into a foreign currency, wait for devaluation, and then move their funds back into the domestic currency, thus realising a speculative gain if their expectation proves correct. If their expectation is incorrect they can move back into the domestic currency without loss, apart from any transactions costs incurred. It is argued that, since there is no risk of loss from speculating on currency devaluation, a weak currency will be further weakened as funds are transferred to another currency and this might precipitate a devaluation that would otherwise not have occurred. However, a country's currency weakens against other currencies only because it has a higher rate of inflation or, if all other things are equal, a lower rate of interest. It makes no difference whether an exchange rate is fixed or floating; the same factors are at work and therefore speculators are able to recognise a weak currency whatever exchange rate regime is operational. In the case of floating exchange rates it is most unlikely that, if economic indicators are pointing to currency depreciation, the exchange rate will actually appreciate. Speculators therefore have the same one way option under floating exchange rates that they have under fixed exchange rates!

Common Mistakes to Avoid A major source of confusion concerning exchange rates is the effect of depreciation on export prices and import prices. When a currency depreciates this changes the foreign price of exports and the domestic price of imports. For example, if the exchange rate for sterling depreciates from £1 = $1.80 to £1 = $1. 70, a good exported from the UK which costs £1000 in the domestic market will cost $1800 before depreciation and $1700 after depreciation. The domestic price is unchanged. It is the dollar price which has fallen. An import, on the other hand, which costs $1080 in the USA costs £600 in the UK before depreciation and £635.3 after depreciation. The dollar price is unchanged. It is the sterling price which has increased. Note that, because depreciation changes the domestic price of imports, if there is any reduction in the volume of imports consumed, total foreign currency expenditure on imports will fall.

Questions and Answers Questions 1 The following is an abstract of an article by

Professor Milton Friedman, published in the

Financiol Times on 18 December. 1989.

Study the passage carefully, then answer each of the questions which follow, explaining your reasoning in each case.

The Case for Floating Exchange Rates

Discussions of the prospects for a monetary union within the Common Market have generally ignored the difference between two superficially similar but basically very different exchange rate arrangements. One arrangement is a unified currency, the pound sterling in Scotland, England and Wales. Further back in time essentially the same arrangement applied in the late 19th century when pound, dollar, franc, etc., were simply different names for specified fixed amounts of gold. A truly unified currency would make a great deal of sense. An alternative arrangement is a system of exchange rates between national currencies pegged at agreed values to be maintained by the separate national central banks by altering domestic monetary policy appropriately. Many proponents of a common European currency regard such a system of pegged exchange rates (the EMS) as a step towards a unified currency. I believe that is a grave mistake. In my opinion, a system of pegged exchange rates among national currencies is worse than either extreme, a truly unified currency, or national currencies linked by freely floating exchange rates. The reason is that the national central banks will not, under modem conditions, be permitted to shape their policies with an eye solely to keeping the exchange rates of their currencies at the agreed level. Pressure to use monetary policy for domestic purposes will from time to time be irresistible. And when that occurs the exchange rate becomes unstable. That was certainly the experience under Bretton Woods. Even in its heyday, exchange rate changes were numerous and when they came often massive. Experience since then has strengthened my confidence in a system of freely floating exchange rates, though it has also made me far more sceptical that such a system is politically feasible. Central banks will meddle, always of course with the best of intentions. None the less, even dirty floating ex-

EXCHANGE RATE SYSTEMS

change rates seem to me preferable to pegged rates, though not necessarily to a unified currency. (a) Why did the author assert that in effect a unified currency arrangement applied worldwide in the late nineteenth century? (5)

(b) What reasons might justify the author's assertion that a truly unified European currency would 'make a great deal of (5) sense'? (c) Why does the maintenance of pegged exchange rates between national currencies involve separate national central banks 'altering domestic monetary policy appro(5) priately'? (d) What did the author mean when he argued that 'pressure to use monetary policy for domestic purposes will from time to time be (5) irresistible'? (e) For what reasons could monetary policy used for domestic purposes cause the ex(5) change rate to become 'unstable'?

W]EC, June 1991 2 Faced with speculative pressure against the pound sterling on the foreign exchange market, a suitable short term counter-measure which could be taken by the authorities would be:

A B C D

sell pounds buy government bonds increase interest rates reduce import duties

AEB, Nov 1991 3 A fall in the foreign exchange value of the pound sterling will benefit the UK balance of payments position when: A B C D

UK imports have low price elasticity of demand. UK exports have high income elasticity of demand. UK interest rates are low. UK exports have high price elasticity of demand.

]MB, June 1991

Answers 1 (a) In the late nineteenth century the gold standard operated. The currency of a country on the gold standard was convertible into a specific quantity of gold per unit of currency. Any currency on the gold

199

standard could therefore be converted into any other currency on the gold standard at a fixed and immutable rate. For example, if gold was priced at $20 per fine ounce in the USA and at £5 per fine ounce in the UK then the sterling/dollar exchange rate would be fixed at £1 = $5. In fact, because all currencies which were on the gold standard were convertible at a fixed rate, effectively a unified currency arrangement existed. (b) A single European currency might confer considerable benefits on participating countries. First, the risk of exchange rate changes would be removed forever. Secondly, there would be savings because it would no longer be necessary to convert one currency into another to facilitate international payments. Thirdly, competition would increase because price differences in different parts of Europe would be easily observable. (c) Maintenance of a pegged exchange rate requires countries to have a similar rate of inflation. If they have different rates of inflation this inevitably leads to those countries with the highest rates of inflation experiencing a balance of payments deficit, and those countries with the lowest rates of inflation experiencing a balance of payments surplus. Ultimately falling competitiveness can only be restored by devaluation of the weakest currencies and unless inflation is brought under control further devaluations will follow. Only by altering domestic monetary policy so as to achieve a rate of inflation compatible with its trading partners can a currency be maintained at some pegged rate. (d) It is argued that in the long run an increase in money growth leads only to an increase in prices. However, in the short run, an expansionary monetary policy might lead to an increase in real variables such as real income and employment. At certain times, such as the run-up to an election, politicians might find the urge to achieve short term economic success irresistible. They might therefore engineer an increase in money growth because of its short run benefits, even though in the long run it leads only to an increase in prices. (e) In the long run, an expansionary monetary policy will lead to higher inflation. If some of the world's major countries expand their money growth rates in an attempt to increase real income and employment in their own economy, world inflation will rise. Over time this will increase the nominal value of surpluses and deficits. If reserves do not rise in line with deficits the growth of international trade will be restricted because there will be insufficient liquidity to finance deficits. This was a major source of instability with the Bretton Woods system.

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INTRODUCTORY ECONOMICS COURSE COMPANION

In addition, an expansionary monetary policy because of its effect on the expected rate of inflation, might motivate speculative capital flows which could destabilise exchange rates. In the longer run, as actual prices increase above prices in other countries, imports will become increasingly competitive and exports will become increasingly uncompetitive. Inevitably the balance of payments on current account will move into deficit and again this will lead to downward pressure on the exchange rate. Unless the deficit countries reduce money growth to levels compatible with the surplus countries, devaluation will be necessary to restore competitiveness. However this can also be a source of instability for the exchange rate system. Devaluation will cause an immediate change in relative prices but the authorities have no way of knowing what the free market equilibrium will be. They are forced to estimate this and adjust exchange rates accordingly. If their estimate is inaccurate, instability will remain and further adjustments will be necessary. In the long run, the only way to remove instability is to reduce money growth so that inflation in deficit countries is broadly similar to inflation in surplus countries. 2 If there is speculative pressure against the pound and the authorities sell sterling they will simply add to the supply of sterling on the foreign exchange market. This would signal to the market their intention to let sterling fall further. The result would be further speculative pressure against sterling. Option A is incorrect. If the authorities in the UK buy bonds on the open market they will drive up bond prices and force interest rates down. Again this would increase speculative pressure against sterling. Option B is incorrect.

If the authorities increase the rate of interest in the UK, sterling will become a more attractive currency to hold and capital flows will be attracted. In other words speculative pressure against sterling would subside. Option C is correct. A reduction in import duties is not a short term measure but in any case it will tend to increase imports in the long run and will therefore tend to increase the size of the balance of payments deficit in the long run. The expectation that this would cause downward pressure on sterling would lead to increased specillative pressure against sterling. Option D is incorrect. The key is C. 3 A fall in the sterling exchange rate will increase the sterling price of imports and the foreign price of exports. If UK imports have a low price elasticity of demand, a fall in the sterling exchange rate will have relatively little effect on foreign currency expenditure on imports. Although there will be some reduction and therefore some benefit to the UK balance of payments, it will be relatively small and therefore we must treat option A as incorrect. A fall in the sterling exchange rate will tend to reduce incomes abroad as demand for UK exports increases. Option B is incorrect. If UK interest rates are low then, as the sterling exchange rate falls, this will tend to encourage a capital outflow. Option C is incorrect. If UK exports have a high price elasticity of demand then, as the sterling exchange rate falls, UK exports will become cheaper abroad. With an elastic demand, this implies that foreign currency earnings from exports will increase. This will be a major benefit to the UK balance of payments. Option D is therefore correct.

EXCHANGE RATE SYSTEMS

201

REVIEW QUESTIONS AND ANSWERS 8 The UK restricts the import of cars.

Questions 1 Assume the following exchange rates are quoted on a particular day: £1 = 3DM, £1 = $1.8 and $1 = 4DM. How can an investor with £1m make a riskless gain by buying and selling currency on the foreign exchanges?

2 If the forward rate of exchange is at a

discount, what does this tell you about the expected future spot rate?

3 Why does a country require reserves of foreign currency when exchange rates are fixed but not when they are floating?

4 When exchange rates are fixed, is the purchasing power parity theory irrelevant? 5 Distinguish between depreciation and deva-

luation.

6 Does speculation stabilise or destabilise exchange rates? Figure 33.4 Supply and demand for sterling

.5

·~ a..

Quantity of ster11ng

Figure 33.4 shows supply and demand for sterling. SS and DD represent the original supply and demand conditions. In Questions 7- 11 begin with the original equilibrium point E and identify the new equilibrium point in each case. Assume that all other things remain equal 7 The rate of interest in the UK rises.

9 Inflation in the UK falls. 10 Inflation abroad rises. 11 There is a sharp increase in the price of oil on world markets.

12 To what extent can the SDR be regarded as money?

Answers 1 Exchange £1m for $1.8m. Convert $1.8m into DM7.2m and then convert Deutschmarks into sterling to obtain £2.4m.

2 If the forward rate of a currency is at a discount this tells us that the spot rate for that currency is expected to depreciate. 3 Reserves of foreign currency are used for intervention purposes to stabilise the domestic exchange rate. When exchange rates float freely there is no intervention by the authorities and therefore strictly no need for reserves. In practice exchange rates are seldom allowed to float freely and even under a floating exchange rate regime there is likely to be some intervention by the authorities, if only to smooth out random fluctuations. 4 The purchasing power parity theory predicts that a higher rate of inflation in one country relative to other countries will be offset by an equivalent depreciation of the exchange rate. If exchange rates are fixed the authorities might intervene directly or increase interest rates to shore up the exchange rate. In these circumstances full purchasing power parity will be maintained in the short run. However, in the long run, if inflation in one country is persistently above that in other countries it will be necessary to devalue the exchange rate. To the extent that devaluation restores purchasing power parity the theory holds. 5 Depreciation is simply a reduction in the external value of a currency through the operation of free market forces. Devaluation, on the other hand, is an administered change in the

202

INTRODUCTORY ECONOMICS COURSE COMPANION

exchange rate from one fixed parity to a lower fixed parity.

6 On the one hand it is possible to argue that speculation, by changing supply and demand for different currencies, might destabilise exchange rates. On the other hand, since speculators buy when they feel a currency is undervalued they increase demand for that currency and thus limit the extent of any depreciation. Furthermore they sell when they feel a currency is overvalued and thus limit the extent of any appreciation of that currency. In this way it is possible to argue that speculation actually stabilises currencies. 7 B, because the higher rate of interest in the UK will reduce the supply of funds to the foreign exchange market as more domestic residents invest at home, and will increase the demand for sterling as more foreign investors place their funds in the UK to take advantage of the higher rate of interest.

8 A, because restricting the volume of car imports will reduce expenditure on foreign cars so the supply of sterling to the foreign exchange market will fall.

9 B, because the lower rate of inflation in the UK will encourage domestic consumers to purchase goods in the home market, thereby reducing the supply of sterling to the foreign exchange market, and it will encourage more foreigners to buy UK goods thus increasing demand for sterling on the foreign exchange market. 10 B, since a rise in inflation abroad has exactly the same effect as a reduction in the domestic rate of inflation. 11 F, because the UK is now a net importer of oil. Higher oil prices would therefore imply an increase in supply of sterling on the foreign exchange market and, as foreigners face higher oil prices, they are likely to cut their demand for UK products.

12 The SDR performs some, but not all, of the functions of money. It is a unit of account and a standard for deferred payments, but there are limits on its acceptability in settlement of a debt. The SDR cannot therefore function as a universal medium of exchange.

203

CHAPTER 34

EUROPE'S ECONOMIC COMMUNITY

Topic Summary Introduction The European Community or, as it is more simply known, the EC, currently has twelve members. These are Germany, France, Luxembourg, the Netherlands, Belgium, the UK, Denmark, Portugal, Spain, Greece, Italy and Ireland. These countries have adopted a common external tariff against imports into the EC and certain common policies in certain key areas such as regional policy, transport policy and policy with respect to the movement of labour and capital. Two important policies are summarised below, but first we consider the static and dynamic effects of abandoning trade restrictions within the EC.

Static effects The static effects of abandoning restrictions on trade refer to trade creation. Trade creation occurs when the removal of restrictions on trade permits greater specialisation by countries in areas where they have a comparative advantage. The result is that higher cost suppliers are replaced by lower cost suppliers. The effect on real income benefits all member states.

Dynamic effects The dynamic effects of abandoning trade restrictions occur over time and take the form of increased efficiency. One factor that will promote increased efficiency is that the larger market will create greater scope for economies of scale. Increased trade might also lead to improvements in the infrastructure, such as improved road and rail networks. The removal of barriers to trade will also encourage greater competition between firms in the EC.

The Common Agricultural Policy (CAPJ Aims of the CAP The Common Agricultural Policy of Europe has several aims: • • • •

To increase farm yields. To stabilise farm incomes so that independent farming communities survive. To stabilise agricultural prices which in free markets are subject to wide fluctuations. To ensure adequate supplies of food within the Community.

Operation of the CAP To achieve these aims farmers are guaranteed minimum prices for their produce and, where necessary, intervention takes place through the Agricultural Guidance and Guarantee Fund to ensure these guaranteed prices are achieved. To avoid competition from abroad a variable import levy is imposed on food imports to ensure that the price of such imports is at least equal to EC farm prices. Figure 34.1 is used as a basis for explanation. In Figure 34.1, SS and DD represent the initial supply and demand conditions of an agricultural commodity in a particular year. The equilibrium price of this commodity is Pc and let us assume that this is also the guaranteed minimum price. In the following year the supply curve of this commodand in a free market the ity increases to equilibrium price will fall to P. However, since Pc is the guaranteed minimum price, there will be a surplus of QQ1 and the authorities will be compelled to purchase this surplus in order to maintain the guaranteed minimum price. In years when supply

sl sl

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INTRODUCTORY ECONOMICS COURSE COMPANION

Figure 34.1 An increase in supply causes an agricultural surplus, which is sold into intervention to maintain the guaranteed minimum price

D

s

s

falls, if the surplus has been stored, it can be sold to avoid a sharp rise in price. In other cases, the surplus is sold on world markets outside the EC at subsidised prices.

Problems with the CAP Effects on other countries A major problem with the CAP is that it prevents those countries with a comparative advantage in the production of food from fully exploiting that comparative advantage. The variable levy on imports of foods protects Community agriculture from competition from lower cost suppliers. This involves a serious misallocation of global resources. A further problem is that agricultural surpluses are often sold on world markets at subsidised prices. This again reduces the gains from trade for those with a comparative advantage in the production of food and implies trade diversion. This has brought the EC into sharp conflict with the USA in particular, and with GATT in general. Sales of food surpluses to third world countries have also caused a decline in agricultural production in those countries to the extent that when drought occurs their already inefficient agricultural sector cannot produce sufficient food to feed the population. The result is that pressure is put on the EC to donate food to countries where the population is starving partly because of EC agricultural policy. In other words the CAP is contributing

to inefficiency in third world agriculture, which exacerbates the effect of a drought. Agricultural Surpluses Another problem with the CAP is that the guaranteed prices have encouraged overproduction of many commodities, with the result that huge 'mountains and lakes', the term used to describe stocks which are sold into intervention and stored, appear. These mountains and lakes are a problem for two reasons. Their increasing size implies that the EC incurs increasingly heavy storage and intervention costs. These costs are financed through the Community's budget, and this in turn is financed by taxpayers in all Community countries. Misallocation of Resources There is no specific formula that links the guaranteed price farmers receive and the free market equilibrium price. It is suggested that in some cases the guaranteed price is significantly above the free market equilibrium, while in other cases it approximates more closely to the free market equilibrium. The effect is to distort the allocation of resources within the agricultural sector. Increased Inequality of Farm Incomes Larger farms produce a greater output than smaller farms and therefore benefit from the higher farm prices under the CAP to a greater extent than smaller farms. The effect is to increase inequality in farm incomes. Increased General Inequality Since the CAP involves maintaining relatively high food prices it discriminates against the poorer people in the Community. Its effects are therefore regressive.

Reform of the CAP On 21 May 1992, EC ministers agreed to a reform of the CAP. The reforms, which are to be implemented in July 1993, are summarised below. Reduction in Guaranteed Prices The guaranteed price at which grain can be sold into intervention is to be reduced by 29 per cent. In 1992, there were 26m tonnes of surplus grain in EC stocks and this figure is expected to rise to 40m tonnes by May 1993. Farmers are to receive compensation of about £36 per tonne on their 1992 output provided they 'set aside', that is, withdraw, 15 per cent of their arable land from production. The guaranteed price of beef is to be reduced by 15 per cent with the aim of reducing the 800 000 tonnes of frozen beef which were in store in 1992. Similarly the price of butter is to be cut by 5 per cent

EUROPE'S ECONOMIC COMMUNITY

over two years with the aim of reducing the 800 000 tonnes butter mountain that existed in 1992.

Reduction in Export Subsidies Export subsidies, which have been a source of contention in the international community, are to be reduced but are not to be phased out altogether. The effect will be to keep EC export prices at competitive levels in world markets

Effects of Reform It may seem that the reduction in grain prices will offer a solution to overproduction of grain. However farmers will undoubtedly set aside the least productive sections of land and this, added to expected productivity increases on the larger farms (20 per cent of farmers produce 80 per cent of EC output), has led to estimates that, by the end of the century, wheat production could rise to lOOm tonnes, 25 per cent more than in 1991! The payment of subsidies will also leave unresolved the problem of inequality between larger farm incomes and smaller farm incomes. Since all farmers receive subsidy at the same rate the problem will be perpetuated and if, as expected, productivity continues to rise on the larger farms, inequality will continue to increase in the future. Because export subsidies will maintain EC prices at competitive levels in world markets there is little doubt that these subsidies will remain a problem for the EC vis d vis the international community. In particular, the subsidies will continue to result in trade diversion and will do little to encourage efficiency in third world countries. If pressure grows, for example from GATT, further reductions in the export subsidy may well be necessary.

The European Monetary System (EMS) The EMS has three components: The Exchange Rate Mechanism (ERM), the European Currency Unit (ECU) and European Monetary Cooperation Fund (EMCF).

The Exchange Rate Mechanism The ERM is an agreement to maintain fixed exchange rates among participating currencies which

205

float against non-participating currencies. Within the ERM, currencies are allowed to diverge from the fixed parity by agreed limits. Currently the limits of fluctuation are ± 6 per cent for currencies in the wide band of the ERM, and ± 2.25 per cent for currencies in the narrow band of the ERM. When a currency approaches its limits in the ERM, the authorities intervene in the way described on p. 196 to ensure that the margins of fluctuation are not breached. If there is persistent downward pressure on a currency in the ERM the most likely short term course of action will be for the authorities to increase the rate of interest.

The European Currency Unit (ECU) The ECU is a basket currency or weighted average of all EMS currencies. It consists of a fixed amount of all participating currencies, each weighted according to its importance in the EC. A major function of the ECU is to act as a unit of account and an increasing amount of borrowing and lending is carried out in ECUs which can, if necessary, then be converted into any EMS currency.

The European Monetary Cooperation Fund (EMCF) The functions of the EMCF are to be taken over by the European Central Bank once this is established, possibly in 1995. One of the main functions of the EMCF within the EMS is to provide short term assistance when a country is faced with downward pressure on its currency within the ERM and requires credit for intervention purposes.

Benefits of ERM Membership The UK joined the EMS when it was created in 1978 but did not participate in the ERM. It joined the wide band of the ERM in October 1990 but withdrew from the ERM in September 1992. Since then there has been considerable discussion about whether the UK has gained from ERM membership.

Lower Inflation There is no doubt that ERM membership was a major factor in achieving lower inflation in the UK. ERM discipline might work in a number of ways. One argument is that the need to maintain the fixed exchange rate within its agreed band forced the authorities to exercise tight control

206

INTRODUCTORY ECONOMICS COURSE COMPANION

of money growth. In the absence of ERM membership, monetary policy might not have been so tight and inflation might therefore have been higher.

Lower Cost of Reducing Inflation It has also been argued that inflation was reduced at a lower cost in terms of unemployment than might otherwise have occurred. The argument is that those involved in fixing wages and prices were aware of the government's commitment to the fixed exchange rate and therefore, because this implied a tight monetary policy, they realised that relatively high wages could not be passed on in higher prices. Instead it was argued that relatively high wage awards would result in job losses. The result was that wage awards fell and more jobs were preserved than might otherwise have been the case. It is clear that inflation fell after the UK joined the ERM but it is by no means agreed that ERM membership caused inflation to fall . Since 1990, world inflation has fallen and, as a result, inflation has fallen in all ERM countries. It has also been argued that a major factor in reducing UK inflation has been the depth of the recession in the UK. Again recession has been a global phenomenon, but it has been particularly severe in the UK where interest rates were maintained at a relatively high level to preserve the value of sterling in the ERM. The suggestion has been made that the depth of the recession in the UK has been due to the fact that the UK joined the ERM at an uncompetitive rate, that is, sterling was overvalued in the ERM. If this is the case it would certainly increase the severity of the recession in the UK because it would reduce the competitiveness of UK exports in the European market and increase the competitveness of European imports in the UK market. It is impossible to test this proposition conclusively but supportive evidence is provided by the size of the UK balance of payments deficit with Europe when the UK was in the ERM which might indicate an overvalued exchange rate.

Economic and Monetary Union (EMU) Strictly economic union and monetary union are different concepts. Economic union implies the creation of a single market without artificial barriers to trade, a community-wide competition policy, a common regional policy and the coordination of macroeconomic policy-making. Monetary union implies economic union but also involves agreeing to irrevocably fixed exchange rates and the eventual creation of a single currency.

Advantages of Economic and Monetary Union There are many possible advantages of economic and monetary union. It is important to be clear at the outset that there is no disagreement about the benefits of economic union. The issue is whether the EC should proceed to full monetary union. The advantages of EMU are summarised below.

Increased Competition In an economic union there will be an increase in competition because of the elimination of restrictions on trade. However monetary union will further increase competition because price differences between goods sold in different parts of the Community will be more obvious to consumers. Elimination of Exchange Rate Risk In a full EMU there is no possibility of exchange rate changes. It is argued that this will encourage even greater specialisation and trade. Real Resource Savings EMU will lead to real resource savings for the Community as a whole. One source of such savings is that it will no longer be necessary to convert one currency into another to settle international indebtedness. Another source of savings is the reduction in the provision of those instruments such as swaps, futures and options which are designed to provide a hedge against exchange rate changes. Increased Efficiency in the Allocation of Resources There are many ways in which EMU will encourage efficiency in the allocation of resources. Perhaps the most important way is that capital will be free to move to where returns are greatest.

Disadvantages of EMU There are two major disadvantages with EMU and again these are summarised below.

Loss of Policy Sovereignty Any country which joins an EMU surrenders control of its monetary policy. In other words an individual country cannot pursue an independent monetary policy. Monetary policy is dictated from the centre and, since changes in monetary policy can impose costs on a country, the possibility will always exist that certain countries could have achieved a better result outside the union than has been achieved inside the union. Given

EUROPE'S ECONOMIC COMMUNITY the success of the Bundesbank in controlling inflation, German reservations about surrendering control of monetary policy are understandable!

Loss of Exchange Rate Sovereignty Countries

which agree to EMU surrender the ability to vary the exchange rate. Changes in the exchange rate have often been the major means through which price and cost differences between different countries are offset. This adjustment mechanism is surrendered in a monetary union: if a country experiences a balance of payments deficit with other countries the costs of adjustment will be borne by the domestic economy and will take the form of falling real income and rising unemployment. The situation can be illustrated by the trading relationship between Scotland and England. The economic situation in Scotland might well be improved if it were possible to devalue the Scottish currency against sterling.

Common Mistakes to Avoid With respect to economic groupings such as the EC, it is important to distinguish between a customs union and a common market. A customs union is simply a loose grouping of countries with the aim of establishing free trade within the union. A common external tariff is applied to all imports into the union but there is no adoption of any other common policy. Members pursue their own independent domestic polices. Neither is there any intention to adopt a fixed exchange rate or to adopt a common currency between members and there are no political aspirations. A common market is a more formal arrangement whereby countries adopt a common external tariff against imports outside the common market and remove barriers to trade within the common market. However a common market also requires common policies. In particular it requires the free movement of capital and labour within the common market and common regional and transport policies. The EC now satisfies these criteria.

Questions and Answers Questions 1 (a) Explain why the European Community (10) needs a policy for agriculture. (b) Discuss the economic reasons why reform of the Common Agricultural Policy (CAP) has (15) been advocated.

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UCLES, June 1992

2 The European Monetary System could benefit a member country because: 1 2

3 A B C D

it becomes more difficult for a single government to cause inflation at home by increasing domestic demand too rapidly it reduces uncertainty and so helps to stimulate trade between members of the European Community when the inflation rates of European Community Members differ balance of payments disequilibria are less likely to result 1, 2 and 3 are correct 1 and 2 only are correct 2 and 3 only are correct 1 only is correct

AEB, Nov 1991

3 The main aim of the European Monetary System (EMS) is to A B C D E

stabilise exchange rates between Community members stabilise Community exchange rates against the dollar encourage the creation of a common currency in member states eliminate destabilising capital flows in the Community provide funds for member states with balance of payments deficits

Answers 1 (a) There are many reasons why the European Community has adopted a common policy on agriculture. One reason is to guarantee adequate supplies of food within the Community. Other reasons are to stabilise agricultural prices and farm incomes. Very basically the CAP is a system of guaranteed minimum prices for agricultural produce and its operation is explained in terms of Figure 34.2 In Figure 34.2, SS and DD are the original supply and demand curves for some agricultural commodity. The equilibrium price is Pc and for simplicity we assume this is the guaranteed minimum price. Assume that supply now increases to 5 15 1. At the guaranteed minimum there is now a surplus and in a free market price would fall. To avoid this the authorities buy up the surplus which they will either store for release onto the market when supply falls, or sell outside the EC on world markets.

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INTRODUCTORY ECONOMICS COURSE COMPANION

Figure 34.2 An increase in supply causes an agricultural surplus which is sold into intervention to maintain the guaranteed minimum price

-------s

Price

D

...__.....,01

Q

Quantity

Surplus

The operation of the guaranteed minimum price will clearly encourage production and so guarantee adequate supplies of food. It will also avoid fluctuations in the supply of agricultural products which characterise some markets where the cobweb theorem operates. In fact, in the EC, the CAP has been so successful in achieving this aim that surpluses have appeared in many products, including beef and butter. In agriculture price fluctuations are a particular problem because supply can be disrupted by random factors such as changes in the weather which affect the annual harvest. However the problem is exacerbated because the price elasticity of demand for agricultural products is relatively low. Because of this relatively small changes in supply can cause relatively large fluctuations in price. There is another problem because the income elasticity of demand for agricultural products is also relatively low. Therefore, as real incomes rise, demand for food does not rise in proportion. Individuals tend to consume different foodstuffs, better cuts of meat for example, but the total demand for food changes very little. This has an important effect on the growth of farm incomes because it implies that, as real national income rises, farm incomes will rise by a smaller amount. Those who work in agriculture will therefore experience a slower growth in real income than those who work in other sectors. Guaranteed minimum prices for agricultural produce do not give farm workers a guaranteed minimum income. However, they almost certainly

guarantee less fluctuation in farm incomes than would occur in an unregulated market. (b) The CAP clearly works to the benefit of the European agricultural sector but its operation has caused many problems. A major problem with the CAP is that it prevents those countries with a comparative advantage in the production of food from fully exploiting that comparative advantage. The variable levy on imports of foods protects Community agriculture from competition from lower cost suppliers in the temperate zones, such the USA, Canada and Australia. The USA has been particularly critical of the CAP because it increases the imported price of agricultural crops from the USA in the EC. In addition sales of agricultural products from the EC at subsidised prices on world markets have reduced farm incomes in the USA. Reform of the CAP has been high on the agenda in the Uruguay Round of the GATT negotiations. Its operation distorts world markets and causes a serious misallocation of resources. The gains from specialisation and trade are well known and when countries are prevented from exploiting a comparative advantage because of protectionist policies there will be a misallocation of resources. In the case of agriculture, resources could be more optimally allocated if protection for the agricultural sector in the EC was reduced. Sales of exports from the EC at subsidised prices have also caused problems for many third world countries. In such countries the availability of relatively cheap food has depressed agricultural prices and discouraged agricultural production. Investment in agriculture has fallen, with the result that in times of drought serious food shortages have developed and the agricultural sector is too inefficient to respond. Another problem with the CAP is that the guaranteed prices have encouraged overproduction of many commodities, with the result that huge surpluses of many products have appeared. To preserve the guaranteed price these stocks have been sold into intervention and, where possible, stored. However the growing size of the surpluses has presented a problem for the authorities because of the increasing cost of intervention purchases and storage. These costs are financed through the Community's budget, and this in turn is financed by taxpayers in all Community countries. Tax revenues spent on intervention have an opportunity cost and this is borne by the Community as a whole. A further problem is that there is no specific formula which links the guaranteed price farmers receive and the free market equilibrium price. It has

EUROPE'S ECONOMIC COMMUNITY

been suggested that in some cases the guaranteed price is significantly above the free market equilibrium, while in other cases it approximates more closely to the free market equilibrium. The effect is to distort the allocation of resources within the agricultural sector by encouraging farmers to concentrate on production of those crops which offer the highest return. A source of contention within the agricultural community is the fact that the larger farms, because they produce a greater output than smaller farms, benefit from the higher farm prices under the CAP to a greater extent than smaller farms. The effect is to increase inequality in farm incomes and to encourage the trend towards larger farms. The disappearance of smaller farms might lead to the elimination of small farm communities - something the CAP was designed to avoid. Whatever the reasoning behind the operation of the CAP, it implies a high food price policy. Consumer real income has therefore been adversely affected as a result of the CAP's operation. Since the same higher food prices are experienced by all consumers regardless of their real incomes, the CAP discriminates against the lower income groups, pensioners, the unemployed, those in low wage occupations and so on. Its effect is therefore regressive. It is clear that there are many economic reasons why reform of the CAP has been advocated. It has had an adverse effect on the allocation of resources within the agricultural sector. It has also increased inequality within the EC's own agricultural sector and, because of the higher food prices its operation has involved, for the community as a whole. 2 For countries which participate in the EMS the overriding obligation is to gear domestic macroeconomic policy towards ensuring stability in the foreign exchange market. Any country that allows demand to rise at a relatively rapid rate will soon find its currency depreciating against other EMS currencies and will be obliged to reign back aggre-

209

gate demand. To the extent that inflation is also reigned back, a country will benefit from EMS membership. Option 1 is correct. It is widely agreed that fixed exchange rates will reduce uncertainty and as a result specialisation and trade will increase for countries which participate fully in the EMS. Option 2 is correct. When inflation rates diverge between trading partners, balance of payments surpluses and deficits appear. The EMS can do nothing to avoid these. Option 3 is incorrect. The key is B.

3 At its inception the main aim of the EMS was declared to be the 'creation of a zone of monetary stability'. This can only be achieved if exchange rates are stable. Option A is therefore correct. There is no attempt to stabilise Community exchange rates against the dollar - or any other non-EMS currency. Option B is incorrect. There is no doubt that, as the EMS has evolved, the creation of a common currency has become a definite possibility. Furthermore if a common currency is to be created it will be necessary to eliminate fluctuations in EMS exchange rates. However, the main aim of the EMS is not to encourage the creation of a common currency - though it might well have this effect. Option C is incorrect. An important feature of the EMS is that there are no controls on capital flows between member states. It is likely that the EMS will eliminate destabilising capital flows because the need to maintain the fixed exchange rate will lead to changes in the rate of interest when a currency is under pressure in the EMS. However this is not the aim of the EMS. Option D is incorrect. As part of the EMS arrangements funds are provided for those countries which require them for intervention to stabilise their exchange rate in the EMS. However, again, this is not an aim of the EMS. It is simply an integral part of the EMS arrangements. Option E is incorrect. The key is A

21 0

INTRODUCTORY ECONOMICS COURSE COMPANION

~,:.

·..

: ,.-

REVIEW QLJ.ESTIONS AND ANSWERS

Questions What is 'common' in a common market?

2 Why is free competition in transport important in stabilising a single market?

3 Why will the development of the single market by 1992 lead to an increase in cross border mergers?

4 Is full economic union in Europe possible without monetary union? 5 Since their respective inceptions, EFTA has contracted and lost membership while the EC has expanded and gained membership. What political and economic reasons can you think of to account for this?

6 If you were a Japanese business manager how

would you view the likely development of the EC in the 1990s? How would you be likely to respond?

7 Which UK industries do you consider most likely to benefit from the 1992 changes, and which could be adversely affected? Explain your answers.

8 Prepare a case for the siting of a future

European Central Bank in London rather than Frankfurt, Paris or some other continental financial centre.

9 What do we mean by the terms 'trade crea-

tion' and 'trade diversion'? Examine these concepts in the context of the EC.

10 Why was the UK slow to become a full

member of the EMS, and why has it been resisting the idea of European monetary union?

11 What UK professions are likely to experience increased opportunities on the Continent as a result of the 1992 measures aimed at 'freeing' the labour market? How might your likely chosen profession be affected?

Answers 1 A common market is a market in which member governments adopt certain common policies and accept certain common regulations relating to industry and commerce. In particular a common exchange rate policy is required, along with common external tariffs and common policies in industries where subsidies are widely used, such as agriculture and transport. There is also free movement of the factors of production. 2 A. single market cannot exist unless there is free competition in transport. If different countries adopt different regulations with respect to transport, this will restrict competition between goods produced in different countries. 3 Cross-border mergers increased as the Single Market neared completion. One reason for this is that firms outside the EC wish to gain access to the larger European market. Increased intra-EC merger activity also suggested that firms in the EC wished to expand and take advantage of the increased availability of economies of scale. 4 Whether full economic union is possible without monetary union is a controversial issue. Strictly economic union and monetary union are different but it is increasingly argued that, in order to realise the full benefits of economic union, monetary union will be necessary. It is argued that one reason for this is that without a common currency the need to exchange one currency for another will reduce competition by raising costs and by concealing price differences in different parts of the community.

5 EFTA is simply a free trade area without

political ties between members. It does not therefore have the same authority in the international world as the EC. This is particularly important with the world becoming polarised into powerful trading blocs. A major problem with EFTA is that it has no common external tariff against imports. There is simply free trade between members. One

EUROPE'S ECONOMIC COMMUNITY

problem with this is that imports can enter the country with the lowest tariff and can then be sold in other member countries without incurring any other tariff payments. The EC is a customs union with a common external tariff against imports so that it is impossible to evade the tariff of any particular country. The EC also has many common policies towards industry and commerce and the free movement of the factors of production. In these circumstances the potential for efficiency in the allocation of resources is far greater than in a free trade area. Hence the rise of the EC and the decline of EFTA. 6 The creation of the Single Market will make possible vast economies of scale for EC firms, which will increase their ability to compete in world markets. In some sectors this represents a threat to Japanese producers. A logical response of Japanese firms to the creation of the Single Market is to locate subsidiaries inside the EC so that the cost disadvantages associated with the common external tariff will be avoided. 7 One area where the UK is expected to do well as a result of the 1992 measures is pharmaceuticals. In fact the UK pharmaceutical industry is the most profitable in Europe. The UK also seems to have a comparative advantage in the food sector, where value added per worker is twice that in France and Germany. In medical and surgical equipment the UK has a considerable comparative advantage. London's pre-eminence in finan. cial services and especially in the provision of insurance implies that this sector will gain after 1992. Similarly UK airlines are relatively efficient. In certain areas of the manufacturing sector the 1992 measures might result in a loss of market share. The UK motor industry is likely to face even stiffer competition. In the production of many consumer durables the UK appears relatively weak. Increasingly dishwashers and washing machines are imported from Europe. The same is true of machine tools. 8 London has a long history of financial expertise. At one time London was the largest financial

211

centre in the world and even today it remains the third largest It is considerably larger than Paris or Frankfurt. In the financial world, where funds are highly mobile, such a position represents a continuing comparative advantage over most other countries. The ability of London to operate effectively as a financial centre is indicated by the relatively large share of the ECU bond market which London has captured. 9 Trade creation takes place when a high cost source of production is replaced by a low cost source of production owing to the removal of some restriction on trade such as a tariff. In the case of the EC, the completion of the internal market has generated increased efficiency through greater economies of scale and this has resulted in trade creation. Trade diversion occurs when a low cost supplier is replaced by a high cost supplier because some barrier to trade has been erected. The CAP diverts trade to EC countries away from lower cost suppliers of agricultural produce. 10 Membership of the EMS implies some loss of policy sovereignty. In particular with respect to the EMS, monetary policy must be geared towards maintaining the exchange rate within the agreed band. This was the major reason why the UK did not join the ERM of the EMS before 1991 and is a major reason for the UK's withdraw! from the system in 1992. Since EMU implies irrevocably fixed exchange rates and eventually the creation of a common currency, it is the main reason why many UK politicians are resisting pressure to move towards EMU. 11 Most professions will experience increased opportunities on the Continent after 1992 for talented and qualified personnel because qualifications gained in one country will be recognised by all countries. Thus a GP who qualified in the UK will be able to practise anywhere in Europe. It is generally considered that there will be greater opportunities for solicitors, accountants, medical practitioners and nurses, among others.

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CHAPTER 35

PUBLIC FINANCE AND TAXATION

Topic Summary Public finance and taxation are concerned with government expenditure and the way in which funds are raised to finance these expenditures.

The Government's Expenditure Plans As from 1993 the Chancellor will present a macroeconomic statement to parliament in which the government's expenditure plans for the coming years are outlined. This macroeconomic statement will also be the occasion when the Chancellor presents the government's annual Budget which contains the government's plans for raising revenue to meet its planned expenditures. Since the 1980s the level of government expenditure has received considerable attention and efforts have been made to limit its growth. The major reason for this is the view that an increase in government expenditure will crowd out an equiva· lent amount of private sector expenditure. The argument is that, since private sector organisations are compelled to make a profit in order to survive, the private sector will use resources more efficiently than the public sector, where there are no profitability requirements. The implication is that a reduction in government expenditure will increase efficiency in the economy. This view is examined more fully on p. 224. Here we simply consider the basic reasons for government expenditure and these are easily summarised.

Public Goods and Merit Goods We have seen on p. 20 that in a free market certain goods would be underproduced or underconsumed in relation to the optimum level. The government undertakes to ensure a minimum level of provision

of street-lighting, education, health-care and so on, so as to improve the allocation of resources.

Redistribution of Income A major item of government expenditure takes the form of transfer payments to the unemployed, the retired, students in full-time higher education and so on. These transfer payments are made entirely for redistributional purposes and their effect is to reduce inequality in the distribution of income.

Regional Assistance Certain regions such as the north-east, Scotland and South Wales have experienced a fall in prosperity and a rise in unemployment owing to the decline of a localised industry such as ship-building or coalmining. To attract industry back to these regions the government offers financial assistance to firms which create or safeguard additional jobs in the regions.

Interest Payments on the National Debt To meet its expenditures the government sometimes borrows and therefore adds to the national debt. Annual interest payments on the national debt are now about 9 per cent of total annual government expenditure.

The Budget From 1993, the Budget will form part of the Chancellor's macroeconomic statement which is presented to parliament each year in December. When revenue from taxation is less than expenditure, a budget

PUBLIC FINANCE AND TAXATION

deficit exists and the government is compelled to finance the deficit by borrowing. The opposite is true when expenditure is less than tax revenue and in this case the surplus can be used to redeem part of the national debt. The Budget attracts considerable interest among economists because of the effect of changes in taxation and government borrowing on the economy. For example, a change in taxation will have a direct impact on aggregate demand and therefore may effect the level of national income, the rate of inflation and unemployment. This view is examined on pp. 219--20. Here we concentrate on the effect of government borrowing.

The Budget Deficit and the PSBR The Public Sector Borrowing Requirement is the sum of all anticipated borrowing by the public sector over the course of the coming year. It therefore consists of the Central Government Borrowing Requirement, the Local Authorities Borrowing Requirement and the Public Corporations Borrowing Requirement. However, since part of the Central Government Borrowing Requirement is on-lent to other parts of the public sector, attention focuses on borrowing by the central government and, since the vast majority of government borrowing stems from the Budget deficit, this explains economists' interest in the Budget. The effect of the PSBR on money growth depends on the size of the PSBR and the way in which it is financed. If all other things remain equal, the larger the PSBR, the greater the effect on money growth. However all other things might not remain equal and differences in the way the PSBR is financed might have a different effect on money growth. If the PSBR is financed by borrowing from the non-bank private sector, money growth is unaffected. All that happens is that private sector deposits are transferred to the public sector and then, when the public sector spends these deposits, they are returned to the private sector. The effect on money growth is therefore neutral. However the same is not true if the PSBR is financed by borrowing from the banking sector. Here the banks lend to the public sector by creating a deposit which, when spent, will increase private sector bank deposits. In consequence money growth will rise. Money growth also rises if the government borrows overseas. Funds are paid into the government's account at the Bank of England and, when these are spent, private sector deposits will rise.

21 3

The National Debt The National Debt is the total of all outstanding central government debt. It currently stands at over £200bn. Most of the debt is held by UK residents but part is held by foreign nationals living abroad, the result of financing the PSBR by borrowing abroad. However it is not the size of the National Debt which attracts attention, it is whether the existence of the debt imposes a financial burden on the community. There are two strands to the argu· ment. One strand is that, if one generation borrows funds and a different generation repays them, a burden has been transferred from one generation to another generation. The second strand of the argument is that the present generation pays taxes to meet interest payments on the debt. In fact it is not possible to transfer a burden from one generation to another in the way suggested above. For the most part payment of taxes and receipt of interest or debt repayment simply repre· sent a redistribution of income within the commu· nity. The same generation which pays taxes receives interest and repayment when debt is redeemed. To this extent, the community as a whole is neither better off nor worse off as a result of the debt. Nevertheless we might argue that the existence of the National Debt does impose some kind of burden on the community, for the reasons examined below.

External Debt If the government borrows abroad then at the time the debt is incurred the community can import more than it exports, the difference being financed by borrowing overseas. However, when the debt is redeemed, a future generation must export more than it imports. This implies a cut in domestic living standards and therefore the imposition of a burden on the generation that redeems the debt.

Disincentive Effects It is sometimes argued that higher rates of taxation have a disincentive effect on effort and initiative and that this reduces real national income below the level that might otherwise have been achieved. If this is correct it implies a lower standard of living for the community as a whole and hence the imposition of a burden on society.

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INTRODUCTORY ECONOMICS COURSE COMPANION

Costs of Administering the Debt Administering the debt involves a financial cost that would otherwise not exist. The resources used in administering the debt have an alternative use and so there is an opportunity cost, the output that might otherwise have been produced, which represents a burden on society. Again the costs of administration are financed by the taxpayer, which might contribute to any disincentive effect.

Some Taxes Levied in the UK Direct Taxes Direct taxes are levied on incomes, capital gains, or transfers of wealth. The main direct taxes levied in the UK at present are summarised below.

Personal Income Tax This is tax levied on taxable incomes; that is, gross income less certain non-taxable allowances, from employment and selfemployment, as well as unearned income such as interest income on savings. It is by far the most important tax in terms of the amount raised in revenue, accounting for almost 25 per cent of total tax revenue in 1991/92. Income tax is progressive in its effect. A tax is progressive when the marginal rate of tax exceeds the average rate of tax. In the UK in 1992/3, the following rates of tax were levied on taxable earned income. Rate of tax (1/o)

Taxable income(£)

20 25

2000 20700 Over 20700

40

The rate of tax is therefore 20 per cent on the first £2000 of taxable income, 25 per cent on the next £18 700 of taxable income and so on. One problem with personal income tax is the possibility of a disincentive effect on effort and initiative. As incomes rise tax liability rises and this might reduce mobility of labour as individuals are discouraged from moving to better paid occupations. Similarly it might discourage effort because higher incomes paid as a reward for higher productivity might be taxed at a higher rate.

National Insurance Contributions These are levied on personal incomes and are used to finance expenditure on the National Health Service and

certain transfer payments such as state pensions. Revenue from national insurance contributions does not cover the full cost of the expenditure on the items it is used to fund and the difference is made up from revenue from other sources.

Corporation Tax This tax is levied on company profits. It is levied at the rate of 25 per cent for small companies with profits up to £250 000. For larger companies with profits in excess of this the rate of corporation tax is 33 per cent.

Indirect Taxes Indirect taxes are collected by the Customs and Excise Department in the UK. The most important indirect tax levied in the UK is Value Added Tax (VAT). This is levied on most goods and services at the constant rate of 17.5 per cent. Some expenditures, such as medicines and children's clothing, are completely exempt from VAT. One problem with VAT is that all consumers pay the same rate of tax on their purchases, regardless of their personal circumstances. The effect of VAT is therefore regressive since it bears more heavily on the lower income groups than the higher income groups, that is, for any given purchase VAT payments constitute a higher proportion of the income of lower income groups than of higher income groups.

Common Mistakes to Avoid Sometimes there is confusion over whether the existence of the National Debt imposes a burden on the community. This argument was examined in the text, but to emphasise the point, remember that, if the government borrows from domestic residents and this is used to finance transfer payments, there is simply a redistribution of income within the community. Similarly when debt is redeemed there is simply a redistribution of income within the community. Even when domestic borrowing is used to finance real expenditures, such as an increase in road building or the construction of hospitals, it is impossible to transfer any kind of burden from one generation to the next. In these circumstances resources are transferred from the private sector to the public sector at the time construction takes place. It is at this time that any burden is borne by the community because of the opportunity cost involved in increasing the output of the public sector. The operation of a progressive tax can also be a source of confusion. As taxable income rises it is

PUBLIC FINANCE AND TAXATION

only the amount in the higher taxable band which is subject to the higher rate. The higher rate does not apply to total taxable income. Thus in the UK in 1992/93, higher income earners paid tax at three different rates. For example, an individual with taxable income of £40 000 would pay tax at the following rates: Rate of tax ("/o) 20 25

40

Taxable income(£)

Amount of tax paid (£)

400

2000

4 675 7720 Total 12795

20700 Over 20700

Questions and Answers Questions 1 In 1978 the standard rate of income tax in the UK was 33% and the top rate was 83%; in 1990 the standard rate was 25% and the top rate was 40%. Examine the likely economic consequences of these changes. ULEAC, June 1992 Questions 2 and 3 are based on Figure 35.1, which shows how the proportion of income paid in tax varies with income in different situations.

The proportion of income paid in taxation as income changes

Figure 35.1

A

8

.E

D

Level of Income

2 Which curve illustrates a tax which is regressive in its effect?

21 5

3 Which curve illustrates a tax which is proportional in its effect?

4 The government would increase the 'poverty trap' if it lowered unemployment pay child benefits c the standard rate of income tax D income tax thresholds A B

AEB, Nov 1990

Answers 1 Income tax is a tax levied on the taxable incomes of individuals. Taxable income is simply gross income from employment and self-employment as well as income from other sources such as interest paid on savings, minus certain tax-free allowances. In the UK, income tax is progressive and therefore the marginal rate of tax exceeds the average rate of tax. This simply means that there are tax thresholds and, as taxable income rises, a higher rate is applied to income above each threshold. In the UK in 1978, the standard rate of tax was 33 per cent. Those with income above the tax-free allowance but below the next tax threshold would only pay income tax at the standard rate. The highest taxable incomes were subject to a marginal rate of 83 per cent. By 1990 the standard rate of tax had fallen to 25 per cent and the top rate of income tax was down to 40 per cent. The main reason for the reduction in income tax rates is the belief that higher rates of taxation have a powerful disincentive effect which impairs the allocation of resources and discourages effort and initiative. The belief is that, if individuals are allowed to keep more of the income they earn, the disincentive effect will be reduced or even eliminated altogether. Disincentive effects might take many forms, but a great deal of attention has focused on the effect of disincentives on the efficiency with which the labour market operates. The disincentive effect might be particularly acute for those caught in the poverty trap or the unemployment trap. The former refers to individuals with relatively low incomes and who are in receipt of supplementary benefit and who qualify for other forms of state aid, such as free school meals for children, free medical prescriptions and so on. In many cases such individuals have little incentive to accept paid employment since they tend to be unskilled and would earn relatively low wages. Their wages from employment would nevertheless

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INTRODUCTORY ECONOMICS COURSE COMPANION

often become liable for taxation and at the same time they would lose their entitlement to state benefits. This implies an effective marginal rate of taxation well in excess of the standard rate, which would leave many individuals little better off in employment than they would be out of employment. In such circumstances there is little incentive to seek paid employment. The unemployment trap operates in a similar way but is more acute. Here individuals are trapped because the tax and benefit systems operate in such a way that they are actually better off out of work than when they are employed. This, added to the disutility and expense, such as travel to and from work, of accepting employment, actively discourages unemployed workers from seeking employment. It is argued that higher rates of taxation increase the numbers caught in the poverty and unemployment traps and that lower rates of taxation, by allowing individuals to retain more of their earnings, provide a means of reducing the extent of these traps. If this is correct the greater number of workers accepting employment will reduce the unemployment total, increase tax revenue for the government and cut down government expenditure on the provision of benefits. It will also increase real national income as unemployed workers add to the flow of output. Belief in this view of the way the labour market works clearly provides governments with a powerful incentive to reduce the standard rate of taxation. The disincentive effect might also manifest itself in other ways. In particular, higher rates of taxation will reduce the incentive of workers to move to different parts of the country where vacancies exist and/or to change their occupation to obtain employment. Lower mobility as a result of higher rates of taxation will affect workers in different occupations and different income groups. By increasing after-tax income, lower rates of taxation might increase mobility of labour for all groups and so increase the efficiency with which the labour market allocates resources. Again the effects will be widespread. Allocative efficiency will increase because supply will be more responsive to changes in demand. Other benefits will include those outlined above, such as a reduction in unemployment and an increase in real income. There is also some evidence that higher rates of taxation persuaded the most talented individuals to move to countries where taxes were lower. If this is correct higher rates of taxation would again adversely affect the productive potential of the economy. If lower rates of taxation remove the incentive to move

to other countries then the existence of better managerial and research talent will improve productivity in the economy, which will confer benefits on all. Despite this, disincentive effects are not confined to the labour market. It is possible that high rates of taxation will reduce the incentive and ability of individuals to save and invest. Higher rates of income tax, by reducing disposable income, clearly reduce the ability of individuals to save. However, since interest income is also subject to taxation, the incentive to save also falls. If all other things remain equal this might reduce the flow of funds available for investment. However investment will also be adversely effected by higher rates of income tax because dividends paid to shareholders are affected by the rate of tax shareholders pay. Higher rate taxpayers receive a lower rate of dividend than lower rate taxpayers because income tax is effectively deducted at source. Since those on higher incomes are more likely to invest in companies it follows that higher rates of taxation might well reduce the flow of investment funds to firms. Lower rates of taxation might encourage savings in investment in industry and this may have been a factor behind the reduction of income tax rates. If investment is encouraged as a result of reducing income tax rates this will certainly be consistent with the aim of the Conservative government in power when tax rates were reduced of widening share ownership in industry. It might also be argued that higher rates of taxation dissuade individuals from declaring the full extent of their taxable income. The growth of the black economy in the UK is evidence of tax avoidance. The lower rates of taxation introduced in the 1980s and 1990s may have reduced the incidence of tax avoidance by reducing the gain from such illegal behaviour. If this is the case it is possible that tax receipts have increased despite the lower rate of taxation. In general lower rates of income tax are widely believed to have increased a whole range of incentives. If this is correct the effect will be to improve the efficiency with which the labour market allocates resources. This in turn implies a lower rate of unemployment and a higher standard of living than might otherwise have been achieved. If employment has increased there will also have been a reduction in the payment of benefits to the unemployed and this, along with increased tax payments, will have reduced the need for governments to borrow. Since an increase in government borrowing will lead to an increase in money growth, and an increase in money

PUBLIC FINANCE AND TAXATION

growth will cause higher inflation, it follows that the lower rate of taxation may have been a contributory factor in achieving the lower rate of inflation which the UK has experienced in the 1980s and 1990s compared with earlier decades. 2 A regressive tax is one where a declining proportion of income is paid in taxation. The correct option is therefore D. 3 A proportional tax is one where the proportion of income paid in taxation is constant as income changes. The correct option is therefore C. 4 The poverty trap exists when the tax and benefit system operate in such a way as to trap an individual in relative poverty. When an unemployed person accepts employment, tax liability increases while benefit entitlement falls. The result is that, when a person accepts employment, they might very well face an effective marginal rate of tax which is close to 100 per cent.

217

If the government lowered unemployment pay this would reduce the poverty trap (though it might increase actual poverty) by reducing the effective marginal rate of tax when a person accepts employment. Option A is incorrect. The same applies if child benefits are reduced. The loss of benefit after a job is accepted falls and this reduces the effective marginal rate of tax. Again, although this would reduce the poverty trap, it might increase actual poverty. Option B is incorrect. If the standard rate of income tax is reduced this will increase disposable income from employment and will reduce the poverty trap. Option C is incorrect. If tax thresholds are reduced then the level of income at which an individual becomes liable for income tax falls. The effect of reducing tax thresholds would therefore be to reduce after-tax incomes, which would most certainly increase the poverty trap. Option D is correct The key is D.

REVIEW QUESTIONS AND ANSWERS

Questions 1 Summarise the arguments for and against the proposition that progressive taxes have disincentive effects.

2 What is the 'poverty trap'? 3 Using supply and demand curves, show how the incidence of an indirect tax is shared between producers and consumers when the impact is initially on consumers.

4 The UK tax system discriminates heavily against earned income, but leaves wealth relatively untouched. Why is this?

5 Is the National Debt a debt the nation owes itself?

6 How is the PSBR related to the Budget deficit?

Answers 1 Taxes are progressive when the marginal rate of tax exceeds the average rate of tax so that, as incomes rise, the amount paid in tax rises more than proportionately. The main argument in favour of progressive taxation is that, as income

increases, the marginal utility of each additional pound falls. To ensure equality of sacrifice it is therefore essential that, as income rises, the amount paid in tax should increase more than proportionately. The main disadvantage of progressive taxation is that it might have powerful disincentive effects on effort and initiative on the part of individuals. It might also discourage investment.

2 The tax and benefit system sometimes works in such a way that when a person accepts work the tax they pay on earned income, combined with their loss of benefit entitlement, leaves little, if any, improvement in their real income. They are therefore caught in a trap which condemns them to relatively low real income whether they are in employment or unemployed. 3 In Figure 35.2, SS and DD are the original supply and demand curves for a particular commodity. The equilibrium price is initially P. If a flat rate tax is now imposed on this commodity the supply curve will shift to S1S 1 and the equilibrium price will rise to P1. The impact of the tax falls on producers because they are responsible for payment of the tax to the authorities. However the incidence of the tax is partly borne by consumers and partly by producers. The total amount paid in tax is shown by the area

21 8

INTRODUCTORY ECONOMICS COURSE COMPANION

Figure 352 The incidence of an indirect tax which faDs on consumers and producers

s

Price

p1 p

c

1--------,,L-..!.!:....~

t-------:'f'-----7',

s

51

D

Quantity

P1ABC. Since price has increased from P to P1, the area PP1AF is the incidence of the tax which falls on the consumer and the area PFBC is the incidence of the tax which falls on the producer.

4 There are problems with attempts to tax wealth. A major problem is defining what consti-

tutes wealth and even if a definition can be agreed there are problems of valuing wealth for purposes of taxation. It would be extremely difficult to collect a tax on wealth. If wealth owners were forced to sell off some of their wealth this might depress asset prices and would make it extremely difficult to assess tax liability. A wealth tax would also be difficult to administer and expensive to collect. Taxing earned income avoids all of these problems. 5 To a large extent the National Debt is a debt the nation owes itself since the present generation are holders of the debt. However, part of the National Debt, roughly 10 per cent, is held by foreigners and this part of the National Debt is not a debt the nation owes itself. 6 The PSBR is comprised of the Central Government Borrowing Requirement, the Local Authority Borrowing Requirement and the Public Corporations Borrowing Requirement. By far the largest of these is the Central Government Borrowing Requirement and the main component here is the central government's budget deficit.

21 9

CHAPTER 36

STABILISATION POLICY

Topic Summary Stabilisation policy involves government intervention in the economy to offset the fluctuations that occur as a result of the trade cycle. All economies seem to have an in-built tendency to fluctuate between periods of boom and periods of recession. During the boom phase economic activity is buoyant so that output and employment are relatively low but the rate of inflation is relatively high and the current account tends to move into deficit. During the recession phase of the cycle economic activity is depressed so that employment, output and the rate of inflation are relatively low and the current account deficit falls or moves into surplus.

The Aims of Stabilisation Policy The aims of stabilisation policy are easily summarised:

A High Level of Employment A major aim of all governments is to achieve a relatively high and stable level of employment. Unemployment is regarded as a waste of economic resources and imposes costs on the taxpayer to finance the provision of supplementary benefits.

A low Rate of Inflation We have seen in Chapter 28 that inflation imposes very severe costs on society. To achieve and maintain a low rate of inflation is the main macroeconomic goal of all governments.

Economic Growth This can be defined as an increase in real national income and faster economic growth is an important objective of all governments because, if all other

things remain equal, as output rises the standard of living rises.

Income Redistribution Income in the UK is unevenly distributed and in the last decade the level of inequality has increased. Nevertheless this does not imply that governments do not aim to promote a certain amount of equality. Income tax is levied at a progressive rate primarily for reasons of equality. The point to emphasise is that, however uneven the distribution of income is, it is certainly a good deal more even than it would be without the government's redistributional policies.

Techniques of Stabilisation Policy The aim of stabilisation policy is to alter aggregate demand in a counter-cyclical way so as to maintain output and employment at a high level while avoiding the problems of inflation and a deficit in the current account. It has to be admitted at the outset that there is considerable doubt about whether governments have achieved much success in stabilising aggregate demand so as to achieve the aims mentioned above. The current view is that in the long run the economy tends towards a stable equilibrium and that attempts to manipulate aggregate demand bring about changes in money growth which cause changes in the rate of inflation and actually destabilise the economy. The techniques of demand management are particularly associated with a Keynesian view of the economy. The main instrument of demand management is the government's annual budget which is used to implement its fiscal policy, that is, the deliberate manipulation of taxation and government expenditure. As the economy moves into recession, stabilisation policy implies that the government aims for a budget deficit; that is, government expenditure exceeds revenue from taxation.

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INTRODUCTORY ECONOMICS COURSE COMPANION

The implication is that, as net injections increase, a multiplier effect will be generated and the economy will be lifted out of recession. As part of its overall strategy the government might also cut interest rates to stimulate investment and consumer spending. However, in the traditional Keynesian view, monetary policy is comparatively insignificant and slow to take effect. Fiscal policy, on the other hand, is considered capable of bringing about major changes in aggregate demand and produces more rapid results than monetary policy. During the boom phase of the cycle, aggregate demand management implies the opposite policy prescription. A budget surplus increases net leakages and, as aggregate demand falls, inflation falls and the current account improves. Stabilisation policy clearly implies a Keynesian view of income determination and links changes in all other macroeconomic variables to changes in national income. However, the effects of stabilisation policy are not inconsistent with a monetarist view of the economy. During the boom phase of the cycle a budget deficit will result in a reduction in money growth so that inflation will fall and during the recession phase of the cycle the budget deficit implies an increase in money growth and a rise in the rate of inflation.

The Causes and Consequences of Economic Growth The Causes of Economic Growth The causes of economic growth are many and varied. In some cases they are specific to a particular country. For example, the Gulf States have achieved economic growth by exploiting their oil reserves. Such natural factor endowments are not transferrable from one country to another and in this section we focus on more general factors that promote growth.

Capital: Labour Ratio One of the most important factors encouraging economic growth is the ratio of capital to labour. When capital is substituted for labour there is usually a substantial increase in productivity. However, for many of the world's poorer countries where population growth is rapid, it is difficult to achieve even capital widening; that is, to ensure that the capital stock grows at the same rate as the population. Capital deepening, that is, accumulating capital at a faster rate than the labour

force is rising, is an important source of growth for most countries.

Technological Progress Capital deepening will increase economic growth but another major factor is the quality of capital. Where technological progress leads to improvements in the type of capital equipment available to firms, and if all other things remain equal, this will encourage greater economic growth. Technological progress is of course the result of investment in research and development and greater expenditure on this can therefore be an important engine of economic growth. Labour The quantity and quality of labour available is an important source of economic growth. In densely populated countries labour tends to be relatively cheap and this gives those countries an advantage in the production of certain goods. Frequently the availability of relatively cheap labour input will attract investment by large multinational corporations. On the other hand, a relatively large labour force does not guarantee economic growth since it is important that workers are gainfully employed. As well as the quantity of labour, the quality of labour is an important factor promoting economic growth. Other things equal, an increase in the skills possessed by the labour force through training will result in an increase in economic growth. Skills are important because they promote mobility and adaptability to changing conditions and patterns of demand. However, entrepreneurship is also important in generating economic growth and though it is impossible to train entrepreneurs it is true that the more 'enterprising' an economy's population, the greater the prospects for economic growth. Reallocation of Resources One way to increase economic growth is to reallocate resources from low productivity industries to high productivity indus· tries. However, this is not always possible since countries often face stiff competition in international producers who exploit a comparative advantage. For example, in the UK it might seem that economic growth could be increased if resources were transferred from the production of fabrics, where value added per worker is low, to the production of cars, where value added per worker is higher. The problem is that the UK does not have a comparative advantage in the production of cars and such a transfer would therefore not be economically viable. There are far greater prospects for improved living standards in transferring resources from the produc-

STAB/LISA TION POLICY tion of armaments to the production of other goods and services.

Consequences of Economic Growth Improved Living Standards The major benefit of economic growth is that it makes possible an improvement in the standard of living. Greater economic growth implies an increase in the real volume of output a nation produces and, as output rises faster than population, this implies an increase in real income per head. For developed countries, such as the UK, with an ageing population the benefit is obvious. As people grow older and withdraw from the labour market they cease to be producers but continue as consumers. The working population must provide output for the non-working population and, if output per head is constant, this implies a fall in living standards for the population as the number of dependants increases. On the other hand, if output rises faster than total population, it is possible for all groups to experience a rise in living standards - even though the number of dependants is increasing. Greater economic growth also makes possible increased investment without necessarily reducing the total volume available for consumption. This is important because investment provides the potential for even greater growth in the future and will also make possible an increase in funds available for research and development. In the medical world this has led to the development of vaccines which have eliminated many fatal diseases which were once rife. It has also led to improved methods of treatment and has had a profound effect on the quality of life. Environmental Effects Attention often focuses on the adverse environmental effects of economic growth. The exploitation of natural resources often causes environmental damage and imposes negative externalities on the community. The loss of clean air because of production or consumption, for example through the use of motor cars, is an example, while industry is often blamed for loss of clean water because they sometimes dump waste material into the waterways. In recent years acid rain and the greenhouse effect have attracted considerable attention. The destruction of the Amazon rain forest, as well as other rain forests across Asia, has been carried out to increase economic growth in many of the world's poorer countries but has undoubtedly contributed in a major way to the greenhouse effect. Motor cars and coal-fired power stations have also contributed to the greenhouse effect and have been a

221

cause of acid rain which has resulted in dead lakes and forests. Such environmental devastation is regarded by many as a high price to pay for economic growth and must be set against any improvements in material welfare as a result of increased output. However, it could be argued that greater economic growth also provides the resources to combat negative externalities. We have the means to clean up dirty rivers and re-landscape areas which have been devastated by industrial pollution. Despite this, it remains true that a great deal of environmental damage is irreversible. Areas of natural beauty, once destroyed, cannot be recreated. Some of the damage caused by the greenhouse effect may be irreversible.

Questions and Answers Questions 1 According to Keynesian theory, domestic economic activity could be stimulated by

I 2

3 A B C D

a fall in the exchange rate reduced levels of taxation increased government spending 1,2 and 3 correct 1 and 2 only correct 2 and 3 only correct 1 only correct

AEB, Nov 1991

2 Which of the folowing is (are) regarded as an automatic stabiliser?

1 2 3 A B C D E

Tax revenue Social security Exports earnings 1, 2 and 3 1 and 2 only 2 and 3 only 1 only 3 only

Answers 1 If the exchange rate is reduced exports will become cheaper abroad and imports will become more expensive in the domestic economy. A reduction in the exchange rate would therefore tend to stimulate aggregate demand and so option 1 is correct. A reduction in taxation will tend to reduce leakages from the circular flow of income and, since

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INTRODUCTORY ECONOMICS COURSE COMPANION

at least part of the implied increase in disposable income will be spent, aggregate demand will tend to rise. Option 2 .is correct. If the government increases its own expenditure injections will tend to rise either directly, because the government is spending more on goods and services, or indirectly as households spend additional transfer payments. Option 3 is correct. The key is A.

2 An automatic stabiliser functions to reduce the extent of fluctuations in the level of nominal national

,

income. To function as an automatic stabiliser a leakage must vary directly with national income whereas an injection must vary inversely as national income. In other words a leakage must fall as national income falls and rise as national income rises, while an injection must fall as national income rises and rise as national income falls . On this criteria tax revenue and social security payments are both automatic stabilisers whereas exports are not. The key is B.

REVIEW QUESTIONS AND ANSWERS

Questions 1 Are high interest rates an effective anti-inflationary policy, or do they cause inflation?

2 If a government wishes to increase taxes to

reduce inflation, which would be the more effective: income tax or Value Added Tax? Justify your answer.

3 Is it realistic to expect governments to

achieve the aims of macroeconomic policy? Discuss the proposition that governments should neither be praised for all successes, nor blamed for all failures.

4 Do demand management policies ignore the supply side of the economy?

Answers 1 In the short run high interest rates might add to inflation by raising the cost of borrowing. In particular, since mortgage costs are included in the RPI, any increase in mortgage rates will be reflected in an increase in the RPI. However, in the long run, there is no doubt that maintaining interest rates at a relatively high level will depress investment and discourage consumption. It may also keep the exchange rate at an overvalued level, thus reducing exports and increasing imports. The effect will be a reduction in the rate of inflation as output falls and unemployment rises.

2 One view of the economy is that in the long run it is money growth which causes inflation and so it makes no difference whether the government increases direct taxes or indirect taxes. They will

both reduce the extent of government borrowing and will therefore have the same effect on money growth and the rate of inflation. However there may be other factors to consider. An increase in VAT will be reflected in an immediate rise in the price level and to that extent may have a short run inflationary bias. In the long run the effect of higher prices will be to reduce demand and so to reduce inflation. A rise in direct taxes, on the other hand, implies an immediate reduction in disposable income which will more quickly be reflected in a fall in demand and a fall in inflation. In the longer run, if direct taxes have more of a disincentive effect than indirect taxes, higher direct taxes will reduce the efficiency with which the supply side of the economy operates. This implies an increase in the natural rate of unemployment and a lower standard of living.

3 Governments clearly believe in their ability to achieve macroeconomic objectives and therefore it is realistic to expect them to achieve those which they aim to achieve. What seems unrealistic is that governments can achieve all objectives at all times. All economies are subject to random shocks and so it is probably correct that governments should neither be praised for all success nor blamed for all failures.

4 Demand-side policies are based on the assumption that the supply side of the economy simply responds passively to changes in aggregate demand. In other words an important assumption of demand side models is that supply is determined by demand! To this extent demand side models ignore the supply side of the economy.

223

CHAPTER 37

SUPPLY-SIDE POLICIES IN THE UK

Topic Summary Demand-side policies were first introduced in the UK after 1945 and continued to be the main approach to macroeconomic management until well into the 1970s. However, even by the 1960s it was becoming clear that the ability of demand-side policies to deliver macroeconomic success was limited. During the boom phase of the cycle inflation was reaching higher and higher levels and current account deficits were becoming more severe. During the recession phase of the cycle unemployment reached higher and higher levels and in general the rate of economic growth in the UK lagged well behind that of other developed countries. Despite this it was not until the 1980s that emphasis shifted from demand-side policies to supply-side policies. Basically supply-side policies involve the removal of barriers to competition in markets, the return of assets from the public sector to the private sector and the provision of incentives to increase efficiency. The aim is to increase real national output whilst avoiding the problems of inflation. The effect of a successful supply-side strategy is illustrated in Figure 37.1. In Figure 37.1 ASs is the initial short run aggregate supply curve, ASL is the initial long run aggregate supply curve and AD is the aggregate demand curve. The price level is initially P and real income is initially YN· Subsequently, if efficiency in the supply side of economy increases, the short run aggregate supply curve will shift to ASs1 and the long run aggregate supply curve will shift to ASn The effect is to increase the equilibrium level of real income to YNl and to pull down the price level to P 1. It is impossible to illustrate the attraction of supplyside policies more vividly than this!

Figure 37.1 The effect of improved efficiency in the supply side of the economy on real output and

the price level

Price level

Real output

Supply-Side Policies in the UK Taxation An important strand of the supply-side approach is to improve incentives by reducing the burden of taxation and to improve the allocation of resources by reducing tax distortion. To improve incentives, successive Conservative governments have reduced the rate of income tax for all income earners. In particular the highest rate of income tax has been reduced from 83 per cent to 40 per cent and the lowest rate has been reduced from 34 per cent to 20 per cent. This is designed to encourage effort and initiative in the labour market. It provides greater incentive for workers to move to different jobs or

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INTRODUCTORY ECONOMICS COURSE COMPANION

different parts of the country and is likely to have a favourable effect on the poverty and unemployment traps. Similarly corporation tax has been reduced from 52 per cent to 25 per cent. This is designed to encourage investment in industry. Measures have also been implemented to reduce tax distortion . For example, tax allowances on mortgages have been reduced from £30 000 per person in the late 1980s to £30 000 per dwelling. The aim is to reduce the attractiveness of investment in property and thereby to increase the attractiveness of investment in industry. Similarly tax relief on life insurance premiums was abolished in 1984 to encourage investment in company equities.

The Labour Market The aim of supply-side policies in the labour market is to increase efficiency by creating a flexible labour market and by improving mobility. Flexibility has been encouraged by widening the gap between the incomes of those in employment and the incomes of the unemployed. This has been achieved partly by changes in the taxation of incomes, as outlined above. However it has also been achieved by reducing the real value of benefits received by the unemployed relative to the real wage received by those in employment. Successive Conservative governments have also curbed the power of trade unions by a series of Acts which have outlawed secondary picketing, so that only those workers in dispute with their employer may picket their place of work, and have reduced the maximum number of pickets to six. Unions are now obliged to hold a secret ballot before calling a strike. Closed shops can no longer be enforced and an individual cannot be dismissed for refusing to join a trade union. Training and Enterprise Councils (TECs) have also been set up to improve the quality of training in local areas and to ease the transition from education to work. Similarly the Technical and Vocational Educational Initiative (TVEI) aims to ensure that educational provision in schools is geared more towards the demands of employers. The aim is to increase the stock of skills possessed by the UK labour force.

Competition The privatisation programme is also an integral part of the supply-side strategy and reflects a view that private sector organisations operate more effi-

ciently than public sector organisations. There may be many reasons for this. One important reason is that, to survive in the private sector, firms must be profitable. They must therefore aim at increased efficiency to keep costs down. In addition, if shareholders are dissatisfied with company performance they can vote to change the board of directors. Even if shareholders take no action, a poor company performance will be reflected in relatively low share prices and this could encourage a takeover and a managerial shake-out as the new owners seek to improve efficiency. This gives the board a powerful incentive to ensure that a company operates efficiently. Deregulating markets has also been an important strand of the supply-side approach. By removing legal barriers to entry it is hoped that competition in deregulated markets will increase. It is widely believed that competition will provide a powerful incentive for firms to increase their operating efficiency and will result in lower prices as firms attempt to win consumers. In particular there has been a marked increase in competition in the bus and coach industry following deregulation. The capital market has also been reformed and deregulated, one immediate effect of which was a narrowing of the bid-offer spread, that is, the rate at which dealers will buy or sell shares, and a reduction in commissions. The intended effect is to encourage an increase in the number of small investors, thus giving more people an interest in the efficiency of the business sector.

Common Mistakes to Avoid An emphasis on supply-side policies does not imply that there is no role for other macroeconomic policies. For example, in the UK in recent years, emphasis on improving the supply side of the economy has been accompanied by quite a severe disinflationary policy. The main instrument of disinflation has been relatively high interest rates to curb aggregate demand and reign back inflation. Emphasis on the supply side simply implies a belief that in the long run the performance of the domestic economy will be enhanced if the supply side operates more efficiently.

Questions and Answers Questions 1 (a) What do the aggregate demand and aggregate supply curves represent? (8)

225

SUPPLY-SIDE POLICIES IN THE UK

(b) Explain what is meant by the term 'supplyside economics' and outline the effect that 'supply-side policies' may have on the aggregate supply curve. (7) (c) How might policies such as tax reform, privatisation and measures to improve the workings of the factor markets, strengthen the supply side of the economy? (10)

Figure 37.2 Typical aggregate demand and short run and long run aggregate supply curoes ASs

Price level

NISEAC May 1991

2 A 'supply-side' economist would argue that a

reduction in direct tax rates could eventually increase government revenue because 1

2 3

A B C D

incentives to work would increase tax avoidance would fall the propensity to save would fall 1,2 and 3 correct 1 and 2 only correct 2 and 3 only correct 1 only correct

AEB, Nov 1991

Answers 1 (a) An aggregate demand curve simply shows the level of real output that will be demanded at each and every price level. As the price level falls the volume of real output will increase. One reason for this is the real balance effect, that is, as prices fall, the real value of money balances will rise and this will encourage an increase in expenditure. In addition, as the price level falls, exports will become more competitive in world markets and imports will become less competitive in the domestic market. Expenditure may also rise as the price level falls because, as the price level falls, the rate of interest will fall. This might stimulate investment and consumption expenditures. The inverse relationship between the price level and the demand for real output is illustrated in Figure 37.2. An aggregate supply curve shows the different levels of output that will be supplied at different price levels. In the long run the aggregate supply curve is vertical at the natural rate of output. In other words, in the long run changes in the price level have no effect on the level of output. However, in the short run, as the price level rises, aggregate supply will rise. Firms incur costs in anticipation of a particular rate of profit. If the price level rises then the actual rate of profit will exceed the anticipated rate of profit and this will encourage further production.

AD

Real output

In Figure 37.2 AD is the aggregate demand curve, ASs is the short run aggregate supply curve and ASL

is the long run aggregate supply curve. The economy illustrated in Figure 37.2 is in long run equilibrium, with price level P and real output YN· (b) 'Supply-side economics' is the term used to describe measures introduced by the government to improve the efficiency with which the supply side of the economy operates. In other words, supply-side economics refers to those policies designed to increase productivity and to encourage competition. If supply-side policies are successful and productivity does increase then the short run and the long run aggregate supply curves will shift outwards to the right. This indicates that in the short run a greater level of output will now be supplied at any given price level. An increase in productivity implies that a given input of resources will now produce a greater output than previously. In other words the average cost of producing any given level of output will fall, and therefore the expected profitability of any given output will rise. This will encourage firms to increase the amount they supply at any given price level; that is, the short run aggregate supply curve will shift outwards to the right. This is illustrated in Figure 37.3, with the short run aggregate supply curve initially given by ASs and by AS51 after the increase in productivity. Increased competition might also encourage firms to cut costs in order to keep their products competitive with those of rival firms. Again, if costs fall, the expected profitability from production at any given price level will increase and the aggregate supply curve will shift outwards to the right.

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In the long run, if supply-side policies are effective, the increased efficiency with which resources are used will also shift the long run aggregate supply curve outwards to the right. As a result there will be a fall in the natural rate of unemployment. In other words, long run equilibrium will be associated with a lower level of unemployment. Figure 37.3 shows the shift in the aggregate supply curve from ASL to ASn as a result of an improvement in the supply side of the economy. The new long run equilibrium level of output is YM·

The effect of increased efficiency on the price level and real output in the long run

Figure 37.3

ASs Price level

Real output

(c) In the UK, tax reform has been a major supply-side measure. In particular income tax has been reduced so that those in employment are allowed to retain a greater amount of their earnings. The aim is to increase incentives in the labour market so that unemployed workers have a greater incentive to obtain employment, to increase mobility of labour and to encourage workers already in employment to increase their efforts. In all cases the result will be higher productivity of labour. Corporation tax has also been reduced so that firms pay less tax on their profits, thus releasing greater funds for investment and increasing the return to shareholders. If investment does increase, the effect will be to increase productivity and thus strengthen the supply side of the economy. Privatisation is the transfer of assets from state ownership to private ownership. It is designed to increase the efficiency with which enterprises are run and in this way strengthen the supply side of the economy. It is argued that private sector organisations are more responsive to changes in consumer preferences than public sector organisations because

of the need to earn a profit. For the same reason they are likely to be more cost conscious and therefore more efficient than state-run enterprises. Another major advantage is that, if an organisation in the private sector is not run efficiently, its share prices will fall and this will make it vulnerable to takeover. This gives management a powerful incentive to operate efficiently because, if they do not, they will almost certainly lose their jobs, either because the company is taken over or because shareholders vote to change the board of directors and a managerial 'shake-out' ensues. Supply-side policies also include measures designed to increase efficiency in the factor markets. In the UK, capital controls have been abolished so that funds are now free to move to where the best combination of risk and return can be obtained. In addition the capital market has been reformed to increase competition. Fixed commissions by brokers who buy and sell shares on behalf of others have been abolished and full ownership of Stock Exchange firms by non-members is now permissible. Far-reaching reforms have also been introduced into the labour market. It is now illegal to compel an individual to join a closed shop and the number of individuals allowed to picket their place of work is limited to six. Secondary picketing is illegal and unions must hold a secret ballot before taking industrial action. As a result of reducing the power of trade unions and strengthening the rights of individuals it is anticipated that productivity and mobility will both increase. Measures have also been introduced to increase training opportunities for those out of work. In particular Training and Enterprise Councils (TECs) have been established to ensure training is more directly related to local needs. The aim is to make sure that the local labour force possesses those skills required by the local economy so that the labour market is more responsive to the demands of employers. 2 It is widely believed that relatively high direct taxes reduce incentives in the labour market to the extent that many people caught in the unemployment trap or the poverty trap have little incentive to accept paid employment. When direct taxes are reduced, disposable income from employment increases and therefore the incentive to accept paid employment increases. Option 1 is correct. A reduction in direct taxes reduces the gain from tax avoidance. This view is particularly associated with the supply-side view of the economy since a demand-side view assumes a reduction in taxes stimulates aggregate demand. If tax avoidance is

SUPPLY-SIDE POLICIES IN THE UK

widespread a reduction in taxation will have less impact. Option 2 is correct. A supply-side view of the economy does not postulate any relationship between a change in direct tax rates and the propensity to save. Note

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also that a reduction in tax rates may change the average propensity to save but it will not necessarily change the marginal propensity to save. Option 3 is incorrect. The key is B.

REVIEW QUESTIONS AND ANSWERS

Questions 1 Distinguish between demand-side and supplyside policies. 2 How might supply-side policies affect (i) economic growth, (ii) the balance of payments?

3 Has deregulation increased the number of 'contestable markets' in the UK? 4 'Since privatisation simply transfers monopolies from the public sector to the private sector it has no effect on efficiency'. Do you agree with this statement?

Answers 1 Demand-side policies aim to achieve the targets of economic policy Oow inflation, high employment and so on) by varying aggregate demand. They are based on the assumption that the supply side of the economy responds to variations in aggregate demand. Supply-side policies aim to achieve the targets of macroeconomic policy by improving the efficiency with which the supply side of the economy operates. It is assumed that variations in aggregate demand have only a transitory effect on macroeconomic variables such as output and employment. It is further assumed that changes in money growth lead only to changes in the price level in the long run and only by improving the supply side can the government hope to reduce unemployment and increase output. 2 (i) If supply-side policies improve the efficiency with which the supply side operates economic growth will undoubtedly increase. Increased efficiency implies that a given amount of input will produce a greater amount of output. (ii) Similarly supply-side policies might have a favourable effect on the balance of payments for a number of reasons. If resources are used more efficiently then any given level of employment will be associated with a lower rate of inflation. This will reduce the pressure on governments to reflate

the economy in order to reduce unemployment and, to the extent that inflation is lower as a result, the current account will improve. In addition, greater efficiency implies an increase in domestic output and, to the extent that more substitutes will be available for imported goods, the current account may improve. Increased efficiency might improve delivery dates and this might have a favourable effect on exports.

3 Strictly a market is contestable when the costs of entry and exit are low. Since public provision of a good or service through a state monopoly is the most complete barrier to entry we might expect privatisation to increase contestability. In practice the public sector monopolies are natural monopolies where the costs of entry are substantial. Contestability might not therefore change as a result of privatisation. On the other hand, by removing an important barrier to entry, markets which were previously uncontestable might now be contestable. Telecommunications is a case in point. Before privatisation there were no competitors for BT. Since privatisation Mercury, though much smaller than BT, has offered some competition and, as the cost of telecommunications falls, this is likely to increase, with Mercury vying for a greater share of the market and other suppliers entering the market.

4 There is a view that public sector monopolies are less efficient than private sector monopolies because the profit motive has less relevance in the public sector. In the private sector if shareholders do not receive a satisfactory rate of return on their shareholdings they will vote to change the board of directors. In addition, if profits and dividends fall, share prices are likely to fall. In such cases a company might become the victim of a hostile takeover. Corporate raiders are always on the look-out for companies whose shares are undervalued because of incompetent management and after the takeover it is the existing management who usually lose their jobs. This provides organisations which have been privatised with a powerful incentive to improve efficiency.

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CHAPTER 38

DEVELOPMENT AND THE PROBLEMS OF THE LESS DEVELOPED COUNTRIES Topic Summary The developing countries, or less developed countries (LDCs) as they are sometimes called, have a diverse range of characteristics. Nevertheless most developing countries are characterised by certain common features, which we consider below.

Characteristics of Developing Countrie Low Per Capita Income A developing country is a country where real per capita income is low compared with developed countries such as those in Western Europe or Japan. In developing countries infant mortality is high compared with the developed countries and the majority of people have poor health, a low level of literacy, inadequate accommodation and a diet that leaves millions starving. Probably the only thing that all developing countries have in common is their low level of real per capita income. In many, though not all, developing countries there is economic stagnation in the sense that the relatively low level of real per capita income is either constant or falling.

Dominant Agricultural Sector Another characteristic feature of developing countries is that a large proportion of the population is engaged in subsistence agriculture. In other words they raise their own crops to provide themselves with food. They also provide their own clothing and shelter so that there is limited scope for specialisation and exchange - the very activities which characterise the developed countries and which are responsible for the relatively high rates of productivity. In the developed world only a

relatively small proportion of the population is employed in agriculture. The situation is exacerbated in developing countries where many people engaged in agricultural production exist in a situation of disguised unemployment; that is, their marginal product is zero. This implies a waste of resources since those workers whose marginal product is zero could be employed elsewhere with no reduction in agricultural output.

Rapid Population Growth Many developing countries have rapid rates of population growth. In the poorer countries of Asia, Africa and South America population growth has been 2.5 per cent per annum. At this rate of growth a country's population will double in less than thirty years. Such growth rates impose a strain on resources since greater and greater amounts must be devoted to providing health-care and education. If all other things remain equal it also implies an increase in the dependency ratio. In such cases ever-increasing amounts must be devoted to current consumption simply to maintain living standards. In many developed countries population growth is less than 1 per cent and in some cases population is projected to fall in the future.

Vicious Circle of Poverty In many developing countries, particularly where population growth is rapid, there is a little saving, which reduces the resources available for investment. Such countries are caught in the vicious circle of poverty. Because income is relatively low it is devoted almost entirely to current consumption and therefore savings are relatively low. Because of this investment is relatively low and therefore income is perpetuated at a relatively low level. Left to their

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CHAPTER 38

DEVELOPMENT AND THE PROBLEMS OF THE LESS DEVELOPED COUNTRIES Topic Summary The developing countries, or less developed countries (LDCs) as they are sometimes called, have a diverse range of characteristics. Nevertheless most developing countries are characterised by certain common features, which we consider below.

Characteristics of Developing Countrie Low Per Capita Income A developing country is a country where real per capita income is low compared with developed countries such as those in Western Europe or Japan. In developing countries infant mortality is high compared with the developed countries and the majority of people have poor health, a low level of literacy, inadequate accommodation and a diet that leaves millions starving. Probably the only thing that all developing countries have in common is their low level of real per capita income. In many, though not all, developing countries there is economic stagnation in the sense that the relatively low level of real per capita income is either constant or falling.

Dominant Agricultural Sector Another characteristic feature of developing countries is that a large proportion of the population is engaged in subsistence agriculture. In other words they raise their own crops to provide themselves with food. They also provide their own clothing and shelter so that there is limited scope for specialisation and exchange - the very activities which characterise the developed countries and which are responsible for the relatively high rates of productivity. In the developed world only a

relatively small proportion of the population is employed in agriculture. The situation is exacerbated in developing countries where many people engaged in agricultural production exist in a situation of disguised unemployment; that is, their marginal product is zero. This implies a waste of resources since those workers whose marginal product is zero could be employed elsewhere with no reduction in agricultural output.

Rapid Population Growth Many developing countries have rapid rates of population growth. In the poorer countries of Asia, Africa and South America population growth has been 2.5 per cent per annum. At this rate of growth a country's population will double in less than thirty years. Such growth rates impose a strain on resources since greater and greater amounts must be devoted to providing health-care and education. If all other things remain equal it also implies an increase in the dependency ratio. In such cases ever-increasing amounts must be devoted to current consumption simply to maintain living standards. In many developed countries population growth is less than 1 per cent and in some cases population is projected to fall in the future.

Vicious Circle of Poverty In many developing countries, particularly where population growth is rapid, there is a little saving, which reduces the resources available for investment. Such countries are caught in the vicious circle of poverty. Because income is relatively low it is devoted almost entirely to current consumption and therefore savings are relatively low. Because of this investment is relatively low and therefore income is perpetuated at a relatively low level. Left to their

DEVELOPMENT AND THE PROBLEMS OF THE LESS DEVELOPED COUNTRIES

own devices countries often find it impossible to break out of this vicious circle of poverty. The vicious circle of poverty is illustrated in Figure 38.1.

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per capita income. For some countries, whatever policy is adopted to promote development, the best that can be hoped for is limited success unless a policy to reduce population growth is also adopted.

Greater Industrialisation It is sometimes suggested that a major problem of many of the world's developing countries is their heavy reliance on agriculture. The implication is that, if resources could be transferred to the manufacturing sector, where productivity is greater, this would increase development. However it is not easy to transfer resources from one sector to another and in any case the result of moving people from the land is urban population growth on such a scale that there is overcrowding in the towns and cities. Many people live in slum dwellings and even squatter camps, where disease is rife. The real problem is lack of investment in the infrastructure and in industry. However, as we have seen earlier, many countries are trapped in a vicious circle of poverty and it is not easy for such countries to increase their rate of investment.

Development Strategies There is no simple solution to the problem of development. Economists are not even agreed on the causes of lack of development and there is no guarantee that a strategy to increase development which works in one country will work in other countries. Nevertheless for many countries it is clear that a policy on population is an essential ingredient of any development strategy and this is considered below, along with some of the more commonly suggested economic strategies.

The Population Problem Population growth in the developing countries is caused by high birth rates and a falling death rate due to the transfer of medical advances from the developed countries. In many developing countries life expectancy has increased by almost one hundred per cent in less than three decades, but the birth rate is little changed. The problem for many people in developing countries is the absence of any form of benefit system, so that a large family provides a means of supporting elderly relatives. However, for countries where population growth is large, what is good for the individual is not good for the nation as a whole and rapid population growth simply depresses

Increased International Trade A dilemma sometimes exists for countries aiming to increase development is self-suffiency a better strategy than specialisation and trade? Self-suffiency implies a policy of encouraging the growth of industries which produce import substitutes, whereas specialisation and trade implies that additional exports should be generated to pay for the increase in imports that development entails. Selfsuffiency initially looks to be an attractive option since development is not jeopardised by shocks from the international economy. However, developing import substitute industries implies protecting domestic industry from foreign competition and we have seen (p. 180) that this encourages inefficiency in production and in the allocation of resources. We have also seen, in Chapter 30, that countries gain from specialising in the production of those goods and services where they have a comparative advantage compared with other nations. The rise of the 'Asian dragons' (Singapore, Hong Kong, Taiwan and South Korea) in recent years bears testimony to the benefits of growth through trade. Despite this, full specialisation where a country has a comparative advantage might not be a wise strategy if it implies concentrating on a narrow range of products. The problem is particularly acute

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for countries which supply commodities which have low income elasticity of demand and low price elasticity of demand. The low income elasticity of demand implies that growth in the developed countries will exceed growth in their demand for commodities from developing countries so that it will be difficult for the developing countries to grow at the same rate as the developed countries. The low price elasticity of demand implies that changes in supply will cause relatively large changes in price and therefore relatively large changes in the incomes of producers.

Property Rights and Entrepreneurship It is now widely recognised that markets provide the most efficient means of allocating resources. By encouraging the ownership of private property and allowing the profit motive to guide producers, many developing countries have experienced an increase in economic growth. State regulation of the economy stifles initiative, reduces the incentive to increase productivity and prevents resources moving to where they can be used most productively. Deregulation is therefore rapidly becoming an integral part of development strategy in the 1990s.

The Debt Problem For countries trapped in the vicious circle of poverty one possibility is greater international borrowing to finance investment. Developing countries have adopted this strategy for decades but in the 1970s and 1980s borrowing increased dramatically. The term 'debt crisis' emerged in the 1980s when, as a result of rising world interest rates and falling demand for exports from the developing countries, many debtor countries defaulted on the interest payments on their debt. The problems of the debtor countries would undoubtedly have been lessened if borrowed funds had been invested in industries likely to promote growth. This is precisely what happened in some countries such as Singapore, which has had no problem in meeting debt service charges or in redeeming its debts. However, in some cases it appears that funds were used to increase domestic consumption. In brief the response of the developed countries to the debt problem has been: • •

to cut back on lending to the debtor countries; to write off a certain amount of debt;

•

•

to reschedule the majority of debt repayments, that is, to allow the debtor countries longer to meet interest payments and final redemption of the debt; to negotiate lower debt service charges; that is, to reduce the interest payable by debtor countries.

Questions and Answers 1 Coffee and cocoa prices - which have this year

collapsed along with their commodity agreements - are set to fall further in 1990, according to the Economist Intelligence Unit. And a big question mark remains over the possible revival of the two commodity agreements. The rubber agreement is the only international pact still operating. But stabilising rubber prices is made easier by the presence of synthetic rubber, which gains market share if natural rubber prices move too high, according to the Unit's latest report on food, feedstuffs and beverages. The task of stabilising the price of tree crops is inherently difficult because smallholders who dominate both the coffee and cocoa industries - are all too likely to expand production when prices are high, but much less likely to cut production when prices fall. Once the cost of establishing the crop has been borne, prices have to 'fall a very long way indeed before they are lower than the opportunity cost of picking the crop with unpaid family labour' according to the EIU. Therefore very strong agreements are needed to keep cocoa and coffee prices in an agreed range. The EIU believes the producers' inability to agree on the distribution of export quotas is the key to the coffee agreement's problems. Brazil, the world's biggest coffee producer, was at least as much to blame for the collapse of the pact as the US, the biggest consumer, which is generally hostile to all agreements. The cocoa agreement has succumbed to a difficulty common to all cartels - the thrusting newcomer who remains outside, says the report. Malaysia, with its low production costs and tenfold increase in output in 10 years, has led to a structural change in the market, making supplies far less vulnerable to disruption in Africa and Brazil, the two traditional growing areas.

DEVELOPMENT AND THE PROBLEMS OF THE LESS DEVELOPED COUNTRIES

Malaysian producers are against their country's membership of the International Cocoa Organisation because it could lead to restricted exports and threaten the financial viability of their expansion plans.

Source: D. Blackwell, 'Bleak future for commodity pacts and prices', Financial Times, 8 December 1989. Explain the meaning of the view that 'prices have to fall a very long way indeed before they are lower than the opportunity cost of picking the crop with (4 marks) unpaid family labour'. (ii) What does this indicate about the economic rent received by cocoa and coffee (2 marks) producers? (b) The author of the article suggests that stabilising rubber prices is easier than is the case with cocoa and coffee. Explain why (2 marks) this may be so. (c) Why does Malaysia pose a problem for other cocoa producers in their attempt to (6 marks) stabilise prices? (d) The income elasticity of demand for cocoa in the United States has been estimated to be + 0.43*. What relevance has this figure (5 marks) for cocoa producers? (a) (i)

(* The International Cocoa Organisation, London)

ULEAC, June 1992

2 Third World countries aiming to increase economic growth will be hindered by 1 2 3 A B C D

fluctuating primary product prices lack of capital poor infrastructure 1,2 and 3 correct 1 and 2 only correct 2 and 3 only correct 1 only correct

AEB, June 1990

Answers 1 (a) (i) The bulk of the cost involved in coffee or cocoa production is the fixed cost of establishing the crop, that is, planting and rearing of trees. Once these costs have been met, production will be profitable as long as price is greater than the variable cost of production. In the case of coffee and cocoa we are

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told that unpaid family labour is used to pick the crop. In this case production will still take place even at very low prices because of the very low variable cost. Hence the phrase 'prices have to fall a very long way indeed before they are lower than the opportunity cost of picking the crop with unpaid family labour'. (ii) Economic rent is a surplus over transfer earnings. The transfer earnings for unpaid family labour are likely to be very low indeed, otherwise workers would move to where rewards are greatest. This implies that the majority of the earnings of cocoa and coffee workers are economic rent. (b) It is easier to stabilise rubber prices because the supply of synthetic rubber can respond to changes in the market demand for rubber. In other words, when the demand for rubber increases manufacturers can increase production of synthetic rubber. This implies an increase in the supply of rubber in response to the higher demand and this limits the effect on the price of rubber of the increase in demand. Conversely, when the demand for rubber falls, the implied fall in the price of rubber will encourage a cut-back in the production of synthetic rubber. This mitigates the effect of the fall in demand on the price of rubber. The production of synthetic rubber therefore acts as a buffer stock mechanism which reduces fluctuations in price. However coffee and cocoa are grown on trees and cannot be produced by any other process. Any change in demand or supply will therefore result in price fluctuations which cannot be stabilised in the way that rubber prices can. (c) With the exception of Malaysia, cocoa producers belong to a cartel. This is a formal agreement between producers to market their product jointly. This implies that individual producers control supply so as to achieve a monopoly position. Individual producers accept a quota on the amount they supply, the aim being to limit the total supply of cocoa so as to drive up the price of cocoa and thus increase cartel profits above that which could be achieved if cartel members competed against each other in world markets. Malaysia poses a problem for the established cartel because it is not a member and is not therefore bound by the cartel agreement to limit the supply of cocoa. On the contrary Malaysia has increased its output of cocoa tenfold in ten years. This has clearly had a powerful impact on market supply because we are told that there has been 'a structural change in the market, making supplies far less vulnerable to disruption in Africa and Brazil, the two traditional growing areas'. We are also told that

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Malaysia is a low cost producer and this, combined with the increase in the supply of cocoa from Malaysia, will exert downward pressure on cocoa prices in world markets. Since Malaysia is not part of the cartel agreement, it will be difficult for cartel members to stabilise cocoa prices. (d) The income elasticity of demand at 0.43 implies that for each 1 per cent growth in national income in the USA, the demand for cocoa will increase by only 0.43 per cent. For those countries which are major exporters of cocoa this implies that it will be difficult if not impossible to achieve a rate of growth equal to that of the USA. More generally, if the income elasticity of demand for cocoa in the USA has a similar value to that in other developed countries, the implication is that it will be extremely difficult for the cocoa exporting countries to close the development gap between themselves and the developed world.

2 Many developing countries are producers of primary products. The prices of primary products often fluctuate widely because they tend to have a low price elasticity of demand and are prone to fluctuations in supply. Fluctuating primary product prices imply fluctuating incomes for primary producers. In some cases this might represent a formidable barrier to economic growth. Option 1 is correct. Another major problem developing countries face is a lack of capital equipment. In many cases they tend to rely on low cost labour. However capital is much more productive than labour and the absence of an adequate capital stock represents a barrier to growth. Option 2 is correct. An essential prerequisite for growth in the world's poorer countries is a well-developed infrastructure so that raw materials can be transported to the place of production and finished products can be transported to market. Option 3 is correct. The key is therefore A.

REVIEW QUESTIONS AND ANSWERS

Questions

11 Do all developing countries face similar pro-

1 Why is an efficient banking sector important

blems in seeking to achieve economic development?

2 Why is unemployment 'disguised' when a worker's marginal product is zero?

12 Both Mexico and the United States have a high level of foreign debt why is this more of a problem for the former than for the latter?

for developing countries?

3 Who is responsible for the international debt crisis, and what should be done about it? 4 'Successful aid depends upon liberal trade'. Do you agree with this statement?. 5 With reference to a particular country, examine the economic and social effects of underdevelopment 6 Could emigration help solve the problem of

economic underdevelopment?

7 Examine the role of Third World pressure groups such as 'UNCTAD'. 8 What criteria and data would you use to decide if (a) Hong Kong (b) Russia, were developed or developing countries?

9 Is there a 'Third World'? 10 Why might it be in the interest of creditor

countries to reduce the debt burden of developing countries?

13 'With every mouth God sends a pair of hands'. How relevant is this comment to the economic effects of population expansion in developing countries?.

Answers 1 An efficient banking sector is essential so that a nation's savings can be made available to industry to finance investment programmes.

2 When marginal product is zero the last worker contributes nothing to output. It follows that if the last worker was made redundant, total output would remain unchanged. In these circumstances unemployment is 'disguised'. 3 To some extent borrowers and lenders are both responsible for the debt crisis: borrowers because they have often not put funds to the most productive uses and have not directed policies towards ensuring they can service their

·

DEVELOPMENT AND THE PROBLEMS OF THE LESS DEVELOPED COUNTRIES

debts; lenders because they allowed borrowers to overextend themselves and borrow too heavily. However there are many other factors to consider. We might blame the industrialised countries for inflating and driving up interest rates to levels beyond that which the developing countries could afford. We might blame the oil rich countries for driving up oil prices and forcing the developing countries to borrow to finance their current account deficits. Strictly speaking it is not possible to apportion blame for the debt crisis. Neither is it possible to provide a definitive answer as to what should be done about the debt crisis. One possibility is to write the debts off. However this seems an unlikely solution and would be unfair on those countries which have made sacrifices to redeem their debts. The only viable course of action is to go on rescheduling debts so as to give the poorer countries sufficient time to repay them. 4 One argument for providing aid to developing countries is to provide them with capital. However increased investment is pointless if the additional output that is produced cannot be sold on world markets because of protectionist policies. Aid can be very successful in alleviating a crisis in the short term, for example, by providing food to people who are starving. However, in the long term, liberalisation of trade will provide the conditions for production to become profitable in developing countries. This is regarded as the key to successful development. 5 Many factors could be considered here, depending on which country we look at. In many of the world's poorer places poverty leads to starvation and poor housing conditions where disease is rife. Malnourishment can cause problems in the physical and mental development of children. In some countries, for example Brazil, poverty is associated with an explosion in the crime rate. Another problem is that an increasing amount of resources is devoted to dealing with the problems of poverty, so that in many developing countries it is impossible for the population to save, there is little investment and the future prospects are bleak. In an effort to increase investment the Brazilian Government has hewn down large sections of the Amazon Jungle and the timber has been sold for hard currency. This might well help finance investment but it is also likely to increase the greenhouse effect.

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In Brazil, as in many poorer countries, there are vast inequalities in the distribution of income. In many towns and cities luxury residences, where the wealthier people live, overlook shanty towns, where the poorer people live. A growing number of people are homeless, and among the poorer groups literacy rates are low and disease is rife. 6 To have any effect on population size, emigration would need to be on a quite massive scale. Even if this were possible it is the young and the skilled who are most likely to move and this would seriously reduce the development prospects of a country, since it would reduce the incentive of firms to invest. 7 The role of any pressure group is to inform and persuade. Only if we know about a problem can we adopt policies to solve that problem. 8 The basic criterion to compare countries is GNP per capita. However in Hong Kong there is a greater degree of inequality than in Russia, so it would be useful to compare the number of people in different income brackets. Other criteria are literacy rates, number of doctors per head of population and availability of medical care. The majority of people in Russia probably have greater access to medical care than in Hong Kong, where medical care is provided through the private sector. 9 'Third World' is the term used to describe all the underdeveloped nations of the world. In this sense there is very clearly a third world. 10 It might be in the interests of creditor countries to reduce the debt burden on debtor countries because this might encourage debtor countries to make greater efforts to meet interest payments and to redeem the debt. Lower debt charges might also enhance the prospects for trade, and developed countries would benefit from this. 11 Many developing countries face similar problems such as high population growth and high debt/GDP ratios. Many countries are also caught in the vicious circle of poverty. This simply means income is low and devoted mainly to consumption. Because of this savings are low and hence investment is low. Low investment implies low growth of income and so the circle is complete. The more rapid the population growth the more difficult it becomes to break out of the circle. Despite this, there are differences between countries, since the

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severity of the problems facing developing countries varies. 12 The ratio of debt/GDP is much lower in the USA than in Mexico. The USA therefore has a far greater ability to service its debt charges and to redeem the debt than Mexico. 13 The statement implies that every individual is both a producer and a consumer. However other

resources besides labour are required for production, in particular capital equipment. Without sufficient capital many workers simply exist as disguised unemployment. As well as resources, developing countries also need access to markets. In other words, although increased population implies more pairs of hands, people might not always be able to use their hands productively!

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INDEX

A Abnormal profit see Supernormal profit Absolute advantage 171-4, 177, 178 Accelerator theory 124, 126, 128 Accepting houses 140, 143 Acquisitions 42, 63 Adaptive expectations 169, 170 Advertising 42, 58, 65, 73, 78, 89 Aggregate demand 117, Ch.22, 161-3, 182, 197, 209, 219-25, 227 Aggregate supply Ch. 22, 161, 223-5 Aid, bilateral and multilateral 104, 232, 233 Allocative efficiency 182-4, 197, 204, 206, 208, 209, 211, 212, 223, 229, 230 Appreciation of currency 194-6, 198 Arbitrage 146, 147 Asset demand for money 149, 150 Asset stripping 42 Assisted areas 53, 212 Average cost 40, 43, 47-52, 57, 65, 66, 73, 74, 78 Average product 39, 40, 45, 46, 51, 52 Average propensity to save 115, 227 Average revenue 48, 49, 51, 65, 68, 73--6 Average revenue product 93

B Balance of payments 1, 30, 64, 70, 161, 163, 180, 182, Ch. 32, 199, 200, 207, 209, 227 and capital flows 200 exchange rates 196, 197 Balance of trade 121, 122, 186, 187, 190, 191 Balanced budget multiplier 118, 121, 122 Balancing item 186, 190 Ballots 28 Bank deposit multiplier see Money supply multiplier Bank deposits 137-9, 144-7 Bank of England 140-7, 154, 186, 213 Barriers to entry 60, 76, 94, 227

Barriers to trade see Protection Barter 132 Bill of exchange 53, 140, 143 Birth rate 80, 82, 83, 229 Black economy see Underground Economy Black market 28, 31, 32 Bonds 140, 149, 150, 153 Budget 121, 135, 145, 212, 213, 217, 219, 220 Budget line 34, 35 Buffer stock 29 Bulk-buying 41, 46, 71

c Capital 1, 43, 45, 46, 79, 86, 90, 91, 96, 97, 100, 108, 123, 124, 127, 131, 133, 135, 136, 203, 206, 207, 220, 231-4 Capital depreciation see Depreciation of capital Cartels 60, 76, 78, 230-2 Cecchini Report 107 Central bank see Bank of England Centrally planned economies 3--5 Certificates of deposit 140, 143, 144 Cheques 139, 144, 147 Choice (and scarcity) 1-3 Circular flow of income 221 Clearing banks 14 Collusion 76, 78 Common Agricultural Policy (CAP) 29, 181, 203--5, 207-9, 211 Comparative advantage (cost) 172-4, 177, 181, 189, 204, 208, 211, 220, 229 Consumer equilibrium 33--6 Consumer sovereignty 6 Consumer surplus 67, 69 Consumption function 111-15 Contestable markets 227 Corporation Tax 214, 224, 226 Cost-benefit analysis 126 Cost curves long run 51 short run 51

236

INDEX

Cost-plus pricing 167, 168 Costs of production 22, 39, 41, 43, 44, Ch. 8, 57, 132, 134, 225 average 40, 43, 47-52, 65, 66, 73, 74, 78 fixed 47, 49-52 marginal 47, 49-52, 55--9, 63, 65, 67, 68, 92, 98 variable 47, 49, 50-2, 65 Cost-push inflation 160, 161 Council tax 157 Cross-elasticity of demand 13, 14 Current account 186, 187, 191, 192, 195, 200, 219, 220, 223, 227, 233

D Death rate 80, 82, 83, 229 Debentures 53, 54 Debt crisis 230, 232, 233 Deflationary policy (i.e. reducing aggregate demand) 219, 220 Demand 5, 10, 18-20, 22-32, Ch. 6, 55--8, 66, 74, 194-6, 201, 202, 207, 217, 218, 231 aggregate 117, Ch.22, 197, 209, 219-24, 227 for capital 125 elasticity of 12-16, 18, 25, 28 for labour 93-6,98,99,102 for money 149-54 law of 10, 14 Demand management Ch. 36 Demand-pull inflation 160-2, 167, 168 Dependency ratio 228 Depreciation of capital 52, 104, 107, 109, 126 of currencies 194-8, 201, 209 Deregulation 60, 78, 107, 108, 168, 224, 227, 230 Devaluation 188, 197-201 Developing countries 104, 106, Ch. 38 Diminishing marginal utility 33, 37 Diminishing returns 39, 42, 45--7, 49, 92, 93, 98 Direct cost see Variable cost Direct taxes 114, 214, 222, 226 Discount houses (market) 141-3, 145, 146 Discounting to present value (DPV) 123-5, 129 Discriminating monopoly Ch. 12 Diseconomies of scale 40-2, 45 Distribution of income and wealth 20, 106, 107 Division of labour 39, 40, 43, 79, 83, 84

E Economic Economic Economic 230,

development Ch. 38 efficiency see Allocative efficiency growth 79, 219, 220, 221, 223, 227, 229, 232, 233

'Economic miracle', UK 371-2 Economic and monetary union (EMU) 206, 207, 210 Economic rent 97, 98, 231 Economies of scale 40-6, 48, 59, 61, 64, 66, 76, 100, 183, 203, 210 Elasticity of demand 12-16, 18, 26, 28, 34, 37, 51, 52, 55, 63,65,67,69, 71, 72, 74, 75, 98,99, 150, 153, 154, 193, 196, 199, 200, 208, 230, 232 Elasticity of supply 12, 96, 97, 99, 131, 133, 161, 196 Emigration 80, 82, 83, 232, 233 Engel Curve 35, 37, 38 Entrepreneur 55, Ch. 15, 180, 183, 189, 220, 230 Equation of exchange 160 Equilibrium level of income 112, 113, 115--19, 161 Equilibrium price 11-13, 20, 22, 27-32, 61, 74, 203, 204, 207, 209, 217 Equity see Ordinary shares European Community 29, 31, 67, 70, 71, 104, 107, 108, 181, Ch. 34 Eurocurrencies 142, 143 European Currency Unit (ECU) 205, 211 European Monetary System (EMS) 188, 198, 205, 207, 209-11 European Monetary Union (EMU) 156, 206, 207, 210, 211 Exchange controls 179 Exchange Equalisation Account 142 Exchange Rate Mechanism (ERM) 188, 205, 206, 211 Exchange rates 1, 142, 175, 181, Ch.33, 207, 210, 221, 222 Expectations adaptive 169, 170 rational Ch. 29 Expectations-augmented Phillips Curve 163, 164 Exports 1, 28, 30, 64, 68-70, 72, 107-10, 117, 121, 122, 130, 132, 135, 136, 161, 173-8, 182, 185--93, 195, 197-200, 205, 206, 208, 213, 221, 222, 225, 227, 229, 239 External economies 42, 43 Externalities 20-3, 26, 106, 108

F Factors of production fixed 39, 45, 49, 59 variable 39, 45, 49 Financial economies 41 Fiscal policy 146, 147, 168, 220 Fixed costs 47, 49-52, 231 Fixed exchange rates 193, 195--9, 201, 209 Floating exchange rates 193-5, 197, 198, 201 Foreign debt, and developing countries 230, 232, 233

INDEX Free enterprise economies 3--6, 31 Free goods 5 Free trade (and protection) Ch. 31 Friedman, Professor M. 198 Full employment 2

G Gearing ratio 54 General Agreement on Tariffs and Trade (GATT) 180, 204, 205, 208 Geographical mobility 31, 79, 80, 90, 100 Giffen goods 33, 37, 38 Gilt-edged securities 145-7 Government expenditure 107, 109, 117, 118, 121, 122 Gross Domestic Product 104, 105, 107, 109, 191, 192, 233, 234 Gross National Product 104, 107, 109, 124, 125, 128, 190, 192, 232, 233 Growth see Economic growth

H High-powered money Hyperinflation 160

146, 147

Imperfect competition Ch. 13, 93 Import quotas 173, 179 Import restrictions see Protection Imports 1,30, 64,67, 70,104,107,109,110,117-22, 130, 132, 135, 161, 173-7, 179, 181-3, 185-92, 195, 196, 198, 200, 201, 206, 210, 211, 213, 221, 225, 229 Income determination Chs 19, 20, 22 Income effect 33-7, 38 Income elasticity of demand 12-15, 34, 36, 37, 199, 208, 230-2 Income tax 120, 121, 135, 136, 168, 214-16, 223, 224 Increased dimensions 41 Increasing returns 39, 42, 45, 47, 92 Index numbers 105, 109, Ch. 27 Index of Retail Prices (RPI) see Retail Price Index Indifference curves 33--6 Indirect costs see Fixed costs Indirect taxes 114, 214, 222 Indivisibilities 40 Infant industry 180, 182 Inferior goods 14, 33-8 Inflation 1, 8, 22, 30, 105, 135, 137, 153, 154, 156--8, Ch.28, 169, 170, 180, 182, 188, 191, 192, 195202, 205-7, 209, 217, 219, 222-4, 227, 233

237

demand-pull 160-1, 167 core 157 cost-push 160, 161, 167 headline 157 Injections and leakages 112-14, 11!}--21, 220, 222 Integration 42, 45, 46 Inter-bank market 143 Interest rates 6, 25, 114, 125-8, 140, 142, 143-1, Ch.26, 185, 192, 195, 196, 222, 224, 225, 230, 233 and exchange rate 195, 196, 19!}--201 International Bank for Reconstruction and Development (World Bank) 177 International trade Ch. 31, 197, 199, 208 Intra-industry specialisation 286 Investment 62, 64, 84, 85, 100, 107, 108, 111-13, 115, 119, 121, 123, 127, 148, 152, 181, 185, 186, 186, 189, 191, 192, 197, 208, 216, 220, 221, 225, 228--33 accelerator, theory of 124, 126, 128 and rate of interest 125 and saving 112, 113, 228--30, 233 Invisible trade 186, 189, 191, 192

K Keynes,]. M. 111 Keynesian theory of income determination Chs 19, 20, 221 Keynesian theory of interest 14!}--52 Kinked demand curve 74-7

L Labour 1,2, 5,21,39,45,46, 49, Ch.14, 92, 93,98100, 108, 161, 170, 177, 203, 207, 220, 223, 231, 232, 234 market reform, in UK 224 mobility of 30, 31, 79, 80, 85, 167, 214, 220, 224, 226 supply of 79, 80, 93--6, 98, 99, 102 Land 1, 4, 22, 90, 91, 101 Leakages and injections 222 Least-cost combination 48 Less developed countries see Developing countries Liquidity 143, 144, 152 Liquidity preference theory 14!}--52 Liquidity trap 151 Loanable funds theory 148, 149, 153, 154 Local authority bills 140 Local taxation see Council tax London Discount Market Association (LDMA) see Discount House

238

INDEX

Long run 39, 45, 47, 48, 51, 55-7, 59, 60, 74, 76, 90, 91, 98, 130-5, 160, 163, 166, 167, 180, 182, 183, 189, 196, 197, 199-201, 222-7 Lorenz Curve 101

M Marginal cost 47-52, 55-61, 63, 65, 67, 68, 92, 93, 98, 100 Marginal efficiency of capital 125-7, 152 Marginal efficiency of investment 125, 126 Marginal product 39, 40, 45, 46, 51, 52, 92-4, 228, 232 Marginal propensity to consume 111, 113--15, 120 to import 118--20, 122 to save 112-15, 118--22, 148, 227 Marginal revenue 48,55-61,63,67,68, 73-6,92,93 Marginal revenue productivity 92-5, 100-2 Marginal utility 33, 36, 37, 57 Market economies see Free enterprise economies Market failure Ch. 4 Marketing economies 41 Mergers 42, 62, 63 Merit goods 5, 20, 21, 212 Migration 80, 82, 83 Minimum prices 28, 29, 32 Minimum wage 29 Mixed economies 3, 6 Mobility 30, 31, 79, 80, 85, 90, 95, 97, 167, 168, 214, 220 . Models 169 Monetarism 160, 162, 165, 167, 220 Monetary policy 141, 142, Ch. 25, 151, 163, 165, 169, 196, 198--200, 206, 220 Money demand for 149-54 functions of 137, 167, 202 Quantity Theory of 160, 165, 167, 168 supply of 144, 147, 150-2, 154, 160, 162-4, 166, 170, 191 value of see Inflation Money market 140, 141, 147, 151, 153 Money supply 126, 144--7, 150-2, 154, 160, 162-4, 166, 170, 191 definitions of 144 multiplier 138, 139, 144 Monopolies and Mergers Commission 62 Monopolistic competition 58, 73, 74, 76--8 Monopoly 20, 48, 50, Ch.11, 73, 76--8, 227, 231 and competition 60-2 discriminating Ch. 12 Multinational companies 220 Multiplier 113, 116, 118--21, 126, 138, 182, 220

N National Debt 141, 146, 212-14, 217, 218 National Income 100, 126, 127, 213, 216, 222 determination of Chs 19, 20, 22 measurement of Ch. 18 Nationalised industries 89, 142 Natural rate of output 131, 133, 135, 136, 163--8 Natural rate of unemployment 180, 222, 226 Net property income from abroad 104, 105, 107, 109 Non-price competition 77 Normal good 14, 34-6 Normal profits 54--8, 74, 76

0 Occupational mobility 79, 80, 85, 86, 90 Office of Fair Trading 62 Oligopoly 48--50, 74--8 Open market operations 144--7 Operational deposits 141, 144--7 Opportunity cost 2-6, 19, 22, 28, 31, 54, 57, 84, 85, 91, 103, 148, 197, 214, 230, 231 and international specialisation 172-5, 178 Optimum population 80, 81, 85 Ordinary shares 42, 53, 54 Overhead costs see Fixed costs

p Parallel economy see Underground economy Pareto optimality see Allocative efficiency Patents 61, 65 Peace dividend 108 Per capita income 105-7, 109, 110, 158, 228, 229, 233 Perfect competition Ch. 10, 60, 61, 76--8, 92, 93 Phillips Curve 162-7 Pollution 3--5, 23, 26, 108--10, 221 Population 4, 79-85, 105-8, 204, 220, 221, 228, 229, 232-4 expansion in developing countries 228 Poverty trap 215, 217, 224, 226 Precautionary demand for money 149, 152, 153 Preference shares 53, 54 Price discrimination Ch. 12 Price leadership 75, 76 Price mechanism 3--5, Ch. 4, 30 Private sector 3--5, Ch.4, 30 Privatisation 107, 108, 141, 168, 224--7 Production possibility curves 2, 3 Productive efficiency 57, 76, 180, 197

239

INDEX

Productivity 5, 15, 39, 40, 43, 79, 80, 84, 94, 95, 100-3, 107-9, 125, 135, 136, 161, 165, 167, 183, 188, 192, 205, 214, 220, 225, 226, 228-30 Profits 3--6, 11, 42, 49, 54, 62-73, 75, 86--9, 92, 93, 97, 98, 100, 102-4, 126, 127, 141, 143, 147, 15464, 166, 168, 179, 186, 212, 225, 226, 230, 231, 233 normal 54-7, 98 subnormal 55, 56 supernormal 55, 56, 58, 60, 62, 66, 73, 74 Progressive taxes 214, 215, 217 Propensity to consume average 115, 227 marginal 111, 119, 121 Protection Ch. 31 Public goods and services 20, 21, 24-6, 212 Public Sector Borrowing Requirement 213, 217, 218 Purchasing power parity 201

Q Quantity Theory of Money Quotas 179, 184

160, 165, 167

R Rate of interest see Interest rates; Monetary policy Rational expectations Ch. 29 Rationing, physical 27, 28 Real cost see Opportunity cost Regional Development Grant 53, 54 Regional Enterprise Grants 54 Regional selective assistance 54 Regressive taxes 215, 217 Rent see Economic rent Rent controls 29 Resource allocation see Allocative efficiency Retail Price Index see Index of Retail Prices Revenue average 48, 49, 56, 57, 65, 68, 73 marginal 48, 49, 55--61, 63, 67, 68, 73--6, 92 total 48, 49, 55, 65, 73, 74, 98

s Savings 80, 110, 112-15, 148, 228, 233 and investment 90, 148 Scarcity (and choice) 1-3, 5, 6, 91 Short run 39, 45, 47, 48, 51, 55, 56, 59, 65, 73, 91, 130-2, 134, 135, 163, 166-8, 170, 180, 189, 199, 201, 222, 223, 225 Single market 42, 64, 107, 210, 211 Social cost (and benefits) 21-3, 25, 26

Specialisation of countries Ch. 30, 206, 208, 209, 229 of labour 39, 40, 43, 46, 79,83-5,92,100,137 Special Drawing Rights (SDRs) 201, 202 Speculative demand for money 149, 150 Stabilisation policy Ch. 36 Standard of living 6, 70, 80, 105, 106, 110, 123, 158, 180, 213, 216, 219-22, 228 Stock Exchange 54, 127, 226 Subsidies 16, 18, 107, 109, 168 Substitutes 14, 15, 18 Substitution effect 33-7, 38 Supernormal profit 55, 56, 58, 60, 62, 66, 73, 74 Supplementary cost see Fixed cost Supply 4, 11-13, 16--20, 22-5, 27-32, 55--7, 66, 74, 75, 193--6, 201-3, 207, 217, 218, 230-2 aggregate Ch.22, 161, 223-5 elasticity of 12, 96, 97, 99, 131, 133, 161, 196 oflabour 93--6 Supply-side economics 222, Ch. 37 Supply-side policies, in UK Ch. 37

T Takeovers 42, 54, 224, 227 Tariffs 31, 32, 179, 181-4, 203, 207, 210, 211 Tax and Price Index 247, 253 Taxation 6, 109, 114, 121, 221 economic effects of 23 and flow of income 107 reform of 223, 224, 226 Technical economies 40 Terms of trade 172-5, 187, 189, 190, 192 Trade restrictions see Protection Trade unions 168 reform of 224, 226 and wages 95, 96, 98, 100, 103, 134, 161, 162, 165 Training 95, 96, 99, 100, 108, 127, 167, 168 Training and Enterprise Councils (TECs) 224, 226 Transactions demand for money 232, 236--7, 239-40 Transactions in assets and liabilities 186, 189, 190 Transfer earnings 97, 98, 231 Transfer payments 104, 109, 110, 120, 212, 214, 222 Treasury bills 140, 141, 143, 145, 146, 185, 188

u Underground economy 106, 216 Unemployment 1-3, 8, 26, 30, 64, 82, 83, 98, 100, 132, 162-70, 178, 180, 182, 183, 190, 197, 207, 216, 219, 222, 223, 227, 228, 232 and inflation 162--U natural rate of 163--8, 180, 222, 226 trap 215, 224, 226

240

INDEX

Uruguay Round (GATT) Utility 33, 34, 36

180, 181, 184, 208

v Value Added Tax (VAT) 121, 181, 214, 222 Value of money see Inflation Variable costs 47, 49, 50-2, 56, 65 Variable proportions 39 Veblen goods 34, 37 Velocity of circulation 160, 162 Vicious circle of poverty 228-30, 233 Visible trade 186, 191, 192 Voluntary export restraints (VERs) 179

w Wages 15, 29, 30, 93--6, 98-100, 102, 103, 136, 161-3, 166, 169, 170 and inflation 162--6 Wealth 20, 106, 107, 137, 138 White, M. 371-2 Working population 123--4 World Bank see International Bank for Reconstruction and Development

X X-inefficiency 41